One of the most common categories of investment securities is known as cyclical stocks. These are shares in companies that are sensitive to economic or business cycles. When an economy is contracting there prices are particularly vulnerable to a downturn; when an economy is expanding their prices are more likely than other categories of stocks to rise. Here’s what you need to know about cyclical stocks. Consider speaking with a financial advisor before investing in these kinds of securities.
What Are Cyclical Stocks?
A cyclical stock mirrors the state of the economy. This type of stock fluctuates, with share price fluctuations that generally mirror the highs and lows of a country’s business cycle. They are well known for their relative volatility but have the potential for significant gains when an economy is booming. The reverse, of course, is true: they have the potential for significant losses when an economy is contracting or even just stagnant.
Cyclical stocks are available in industries that produce discretionary items and services, that is, wants, not needs. When an economy weakens, people are more focused on the essentials (needs) rather than lifestyle upgrades (wants). So, investor and consumer confidence drops, leading to falling share prices.
Generally, specific market sectors have cyclical stocks. Among them are automakers, airlines, entertainment, hotels and upscale retailers.
Cyclical vs. Noncyclical Stocks
Noncyclical stocks are available in industries that produce nondiscretionary items and services. They are needs, not wants. When an economy strengthens, people are more focused on nonessential items and services. Companies that have noncyclical stocks tend to produce or sell necessary items and services, such as food, power and water.
That tends to make noncyclical stocks a more secure investment because they don’t experience the same highs and lows as their cyclical counterpart. That is because they represent industries that stay consistently in demand, regardless of the economic state of a country.
How Cyclical Stocks Work?
Cyclical stocks reflect the larger overall economy, or the macroeconomic environment, in an economy. So, when a country experiences an upswing, these stocks perform well. Their prices rise, which means you can earn significant returns on them at these times. On the other hand, when the country goes through a recession, these stocks suffer with it. Their prices drop, and it’s possible that investors of such stocks may face losses.
Cyclical stocks follow the business cycle, from expansion to recession and through to recovery. That’s because the companies with cyclical stocks tend to do their best when the economy is strong. They provide goods and services people want when they are financially secure and have the excess to afford them.
Advantages of Cyclical Stocks
When the economy is strong, cyclical stocks perform well. They even tend to outperform the index benchmarks. So, it is possible to make significant returns off of these stocks. The better you are at timing your purchase and sale, the more you are likely to make as well. Watching consumer confidence grow in luxury companies during economic growth periods will help you choose your entry and exit points.
On that note, cyclical stocks are a valuable way to gauge business sentiments. Monitoring them will provide insight into where the economy may move soon. That helps you inform your strategy and maximize your returns.
Disadvantages of Cyclical Stocks
The main disadvantage of cyclical stocks is their volatility, which can be difficult to navigate.
Their fluctuations can mean losses for the unwitting investor. You can lose a significant amount of money if you are not careful. While not exactly timing the market, investing in cyclical stocks requires buying and selling in sync with the business cycle. Because of this, knowledge of the stock market and active analysis of economic trends are necessary.
Cyclical stocks may not be particularly well suited to long-term or buy-and-hold investors. Such investors often take passive approaches that are incompatible with this particular category of securities.
Cyclical stocks are a relatively volatile investment option with great potential for both gains and losses. They are not for the passive, buy-and-hold or long-term investor who has no interest in the business cycle. Instead, a cyclical stock trader needs to be active and monitor the economy carefully. Cyclical stocks provide the opportunity for big returns in the right situation. Examine whether you can handle the risk and potential loss of this type of stock.
Tips for Investing
- A financial advisor has the knowledge necessary to guide investing beginners as they assess invest in cyclical stocks. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you with several in your area in just minutes. Simply answer some easy questions about your financial goals and current situation. Then the program will pair you with up to three advisors for you to choose from. If you’re ready, get started now.
- Trusting volatile investments is a dangerous gamble. If you’re not careful, you can incur significant losses. That’s why it is always crucial to maintain a diversified portfolio. By keeping a balance between risky but profitable assets and lower-risk, lower-yield ones, you can ensure you never lose too much. In combination with a financial advisor, an asset allocation calculator can help you find the right balance for your portfolio.
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