If we stop and reflect on life for a moment, we will realise that each year we experience fewer seasons and that things change during each season. In some areas, the seasons will vary in length and changes happen nevertheless.
Since your money tree is part of nature, it too will change with the different seasons. At times it will sprout new, vigorous growth and the leaves and branches will seem to grow as you watch them while at other times it may appear to be dormant. In the autumn your tree may shed its leaves and sometimes branches will die off.
Nevertheless your tree continues to grow and flourish. It becomes stronger despite the seasons or perhaps because of them.
Just as nature operates according to a seasonal clock, your wealth will be influenced by the economic clock. The economic clock indicates in which particular cycle the economy is in at a point in time.
When you understand the cyclical nature of the investment markets and how to read the economic clock, you can use this information to guide your investment decisions.
Learning to "ride the economic cycle" is one the keys to successful long-term investing. This means being able to read the signs correctly and making the most of investment opportunities as they arise by moving in and out of different investment markets to take advantage of the current cycle.
To many observers, the economy seems to be on a roller-coaster ride - bumpy, unpredictable and uncomfortable. In fact, it's an ongoing cycle, with continuous highs and lows. One of the objectives in developing a sound financial plan is to be able to cope with highs and lows - as well as having the flexibility to seek new opportunities as they arise.
To understand how these cycles work, refer to the diagram of the economic clock above.
This diagram shows that the economy is in a constant state of movement between two opposite points - boom and recession. As you study the cycles, it becomes clearer why booms don't last forever, and why there are always investment opportunities, even during a recession. The major areas of interest are shares, real estate and cash investments such as interest bearing deposits, bonds and debentures. Notice that share prices are the first to rise after the recession period and the first to fall in a downturn, whereas real estate is the last to rise and the last to fall. By watching the movements of interest rates, commodity prices and overseas reserves we can find out which times in the economic cycle will provide the best buying opportunities for shares, real estate or cash investment.
In order for you to build wealth, it is not important to understand all of the factors that create the economic cycles. It is only important to understand that economic activity is cyclical and where we are in the cycle so that you can invest appropriately. It's a bit like driving a car. You don't need to understand the mechanics of how the engine works in order to drive the car.
Historically, we have had major ecomonic downturns or recessions every seven to ten years. While the severity and duration of these vary, it is undeniable that we go through these ups and downs. Here's the typical economic behaviour that is associated with these financial cycles.
Prior to the slump we find the real estate market increasing rapidly to a point of overheating and rising interest rates with the increase demand for money. The high interest rates lead to numerous business failures, growing unemployment and a decline in consumer confidence. Money becomes much tighter and share prices come under pressure. Commodity prices then decrease and interest rates fall as the demand for money declines due to the slowdown. The newspapers at this time are heralding doom and gloom and the property market also declines. At this time we are said to be experiencing a recession.
This is not a terribly comfortable state and the focus now turns to ways of beating the recession. People become conscious of the need to be more productive; they work a little harder and perhaps longer. We tighten our belts, and look at ways to economise and cut down on waste.
The outlook becomes more positive as productivity increases and profits rise again. This leads to a rise in share prices and volumes of shares traded.
Eventually we get back into the boom mentality and the sharemarket rises to record levels as more and more people chase speculative profits. When this market overheats, it often collapses very quickly. Major sharemarket collapses generally occur every seven to eight years.
Tip: you know that the sharemarket is about to collapse when your taxi driver gives you the low down on the latest shares which are about to go through the roof.
During the highs that precede the collapse of the share market, the huge returns possible attract the majority of investment funds at the expense of the real estate market. Similarly, the interest rate returns on cash investments are not very attractive during this time in the cycle as the returns do not match those of the share market.
As the sharemarket reaches the point where the price paid for a share is not justified by the asset backing nor the earnings per share, the astute investor turns to the real estate market.
Usually there is a lag in residential real estate values such that the cost of buying established houses is less than the cost of building new. Since this represents a buyer's market, the astute investor moves into residential real estate before the share market reaches its peak.
As the demand for real estate increases, prices rise, thereby attracting additional investors and buyers who have been putting off the decision to buy.
The real estate cycle usually lasts for two or three years. During this time, values
may increase by around 25% per year. This represents a good return and can be improved by the use of sensible borrowing.
As the real estate market hots up, interest rates also start to rise. The average home buyer is squeezed and finds it difficult to keep up the mortgage payments. More houses are put up for sale and prices start to fall as the demand for residential real estate declines. Commercial and industrial real estate markets often have different cycles to the residential market.
Following the residential real estate cycle, the astute investor will take advantage of the high rates of return offered on cash investments such as interest bearing deposits, debentures and bonds. At this time, the economy is slowing down again and the cycle repeats itself.
As you can see, each type of investment instrument has it's place in the economic cycle and offers greater returns at certain times of the cycle. Likewise, there are times in the cycle which offer better buying opportunities than others. Buying in at the best times allows you to build wealth faster.
About Hans Jakobi
Hans Jakobi is an educator, author and investor. He is the author of six best-selling books including, How To Be Rich & Happy On Your Income which is available at:
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