Boom and Bust Cycles: Causes, Phases and Ways to Protect

The boom and bust cycles are the upward and downward movements of the Gross Domestic Product (GDP) and their long-term trend. It aids in determining the level of production in the economy as well as the performance of economic indicators such as employment, inflation, stock performance, and investor behavior.

 

Workers are more likely to lose their jobs during recessions and to see their wages rise during booms. Typically, employment follows the economy's progress through the business cycle. As the economy expands during the "boom" phase, employment and incomes rise. During the "bust" period, employment declines as the economy slows.

 

 

What is a Boom and Bust Cycle?

 

The boom and bust cycle is characterized by alternating periods of economic growth and decline. It is another term for the business or economic cycle. These phases, according to the Federal Reserve Bank of Richmond, are unavoidable. The more you understand about their phases, causes, and history, the better you will be able to protect yourself from their consequences.

 

The boom and bust cycle is a cyclical process of economic expansion and contraction. The boom and bust cycle is a key feature of capitalist economies and is sometimes referred to as the business cycle.

 

During a boom, the economy expands, jobs are plentiful, and the market provides investors with high returns. The economy contracts, people lose their jobs, and investors lose money as a result of the subsequent bust. Boom-bust cycles last for varying lengths of time and have varying degrees of severity.

 

The United States has gone through several boom and bust cycles since the mid-1940s. Why do we have a boom- bust cycle  instead of a long period of steady economic growth? The answer lies in how central banks manage the money supply.

 

During a boom, a central bank makes credit more accessible by lending money at low interest rates. Individuals and businesses can then borrow money easily and affordably and invest it in things like technology stocks or real estate. Many people profit from their investments, and the economy grows.

 

People will overinvest when credit is too easy to obtain and interest rates are too low. This excess investment is referred to as "malinvestment." There will not be enough demand for, say, all of the newly built homes, and the bust cycle will begin. 

 

Overinvested in items will depreciate in value. Investors lose money, consumers cut back on spending, and businesses lay off workers. As boom-time borrowers become unable to make loan payments, credit becomes more difficult to obtain. Recessions are used to describe bust periods; if the recession is particularly severe, it is referred to as a depression.

 

Phases of Boom and Bust Cycles

 

The boom and bust cycle has four phases, which have been mentioned below :

 

1. Boom

 

Growth is positive during the boom period. If economic growth remains in the healthy range of 2% to 3%, it can remain in this phase for years. 2 It is associated with a bull market, rising home prices, wage growth, and low unemployment.

 

Unless the economy overheats, the boom phase usually does not end. Inflation is caused by an excess of liquidity in the money supply. As prices rise, investors experience irrational exuberance. The growth rate exceeds 4% for two or more quarters in a row.

 

When the media declares that the expansion will never end, you know you're nearing the end of a boom period. At that point, even the grocery clerk is profiting from the latest asset bubble.

 

2. Peak

 

The peak occurs at the end of the boom or expansion phase. According to the National Bureau of Economic Research, it is the point at which the economy ceases to expand.

 

This is best defined as the inflection point; during this phase, the economy ceases to expand. It denotes the end of the boom period and is also referred to as the Peak. Stock prices are frequently choppy and volatile, and housing demand is declining.

 

3. Bust

 

The bust phase is the business cycle's contraction stage. It's brutal, nasty, and mercifully brief. It usually lasts 11 months. 4 The economy is contracting, the unemployment rate is at or above 7%, and the value of investments is declining. If it lasts longer than three months, it is considered a recession. A stock market crash can set it off, followed by a bear market.

 

A stock market crash has the potential to trigger a recession. As stock prices fall, everyone loses faith in the economy's health. When investors are unsure about the future, they withdraw their investments. They reduced business activities like purchasing, hiring, and investing.

 

4. Trough

 

The trough is the point at which the economy begins to recover and the period of decline ends. While the economy is no longer growing, it is also not contracting; this is a phase identified as the start of a new boom period, which would otherwise cause the economy to stagnate.

 

The boom cycle promotes economic growth because employment rates are higher, resulting in a higher growth rate. When investors make too many investments at once, the value of these investments falls into a bust phase. Central banks, such as the Federal Reserve Bank, set monetary policy in response to these business cycles.

 

 

Causes of Boom and Bust Cycles

 

The boom and bust cycle is caused by central banks' monetary policy, which lowers interest rates and freely lends capital during periods of prosperity. The economy then overheats as a result of irrational and unsustainable investment behavior.

 

Banks lend money to individuals and businesses at low interest rates during times of prosperity. This money is then invested in a variety of areas, including technology, stocks, and real estate, with investors earning higher returns as the economy grows.

 

There are numerous reasons and theories that explain the occurrence of the business cycle. There is no single static explanation for the same; rather, it is a medley of several factors that lead to boom and bust cycles.

 

1. Demand and Supply

 

A boom-and-bust cycle can be caused or exacerbated by rising or falling supply and demand. When demand falls, the economy begins to contract.

 

2. Human Behavior

 

People's future confidence has a significant impact on boom-and-bust cycles. When people are optimistic about the future, they are more likely to take larger, more frequent risks. Likewise, when people lose faith in the future, they are less likely to take risks.

 

3. Financial Resources

 

During a period of economic expansion, more investment opportunities coexist and emerge. With banks' lower lending standards, people and businesses feel compelled to take advantage of these opportunities. 

 

Easy access to capital means more opportunities and revenue for banks. When investments become risky, banks increase lending requirements and make capital more difficult to obtain in order to protect themselves.

 

Ways to Protect Yourself from Boom and Bust

 

Rebalancing your investment portfolio once or twice a year is the best way to protect against the boom and bust cycle. It will ensure that you buy low and sell high automatically. For example, if commodities perform well while stocks perform poorly, your portfolio will contain an excessive amount of commodities. You'll sell some commodities and buy some stocks to rebalance. This forces you to sell commodities when they are high and buy stocks when they are low.

 

It is extremely difficult to predict boom and bust cycles. As a result, market timing is critical in the stock market trading domain. Unfortunately, most retail investors are unable to properly time their investments because they are unaware of the actions of institutional investors. As a result, they can only analyze when there is a clear indication of the economy's direction.

 

This does not, however, imply that retail investors cannot earn sufficient returns from uptrends while avoiding downtrends. Retail and institutional investors can both take the following steps to avoid capital loss during the cyclical change:- 

 

1. Diversification

 

It is always beneficial to have some level of diversification in both the investment and income portfolios. A good mix of equity, bonds, and commodities, for example, will protect the investor from high inflation or bust cycles while providing good returns during boom cycles. Investors who are heavily reliant on a single sector for income should avoid making financial investments solely to diversify their risks in that sector.

 

2. Savings

 

Maintaining a healthy level of savings in a retirement fund and for the bust cycle periods is a good strategy because it can be useful when the economy is underperforming. Furthermore, deferring consumption that is not immediately required is a good strategy.

 

3. Hedging

 

It is always a safer strategy to forego profits in order to invest in hedging instruments such as derivatives, which allow investors to control their losses in the event of an unforeseen event. In a Boom market, the tools expire out of the money, so only the cost is a drag on the return.
 

4. Recognizing the Cycle Phase

 

You must have a clear and profound understanding of the cycle to know when to invest for maximum profit. Recognizing the cycle phase helps you predict the cycle and helps in saving money. 

 

The boom and bust cycle is an unavoidable part of the economic framework. As a result, it is best to stay current with the changing economic scenario and take the necessary actions as the circumstances dictate in order to minimize losses during busts and maximize gains during booms. 

 

Tracking fiscal and monetary policy can help you stay aware and ahead of bad situations, as well as anticipate profitable situations and adjust your savings, investment, and consumption strategies accordingly. 

 

Also Read | Credit Cycle and Business Cycle

 

Boom and bust cycles are simply a part of the economy; their occurrence is natural and unavoidable. History demonstrates that, just as busts do not last forever, neither do booms. With this in mind, it is only beneficial for everyone to be wary of busts and avoid pitfalls.

 

The boom and bust cycle is a term used to describe the alternating periods of economic growth and decline that are common in many capitalist economies. The term "boom and bust cycle" refers to the fluctuations in an economy caused by persistent expansion and contraction. Expansion is linked to prosperity, while contraction is linked to either a recession or a depression.