With the financial markets having been in such turmoil over recent years, you may have seen more talk of “cyclical stocks”. But what exactly are they?
Cyclical stocks: A definition
A cyclical stock is, at its simplest, a stock whose performance mirrors that of the overall economy. When an economy grows, the performance of a cyclical stock improves. When an economy declines, the stock does the same. This means that their price is subject to any fluctuation in the market.
When the economy is strong, the demand for discretionary items is higher – while the reverse is true when the economy is weak. For this reason, many businesses that are classed as cyclical stocks tend to be those within industries that are dependent on discretionary spending: industries like travel, hospitality, leisure, entertainment, cars and luxury retail.
These businesses can range from the very small to the very large, and span a whole host of sectors. When times are tough their customers reduce their spend. When this happens, these businesses see a decline in revenues, which can then affect their share prices.
The pros and cons of cyclical stocks
There are many reasons why investors include cyclical stocks in their portfolios. If an investor manages to buy into a cyclical stock at the end of a downturn, they have the potential to be rewarded highly. By tracking owned cyclical stock performance, investors may also be able to predict how the economy will be changing, which can impact on how they handle the rest of their portfolio.
While identifying cyclical stocks can be easy and there is potential for reward, there is also plenty of risk. Buying stocks in smaller businesses can lead to big returns – but also potentially big losses.
What’s more, if you buy at the wrong point in the cycle, it can take time for your investment to reap rewards – if at all. In addition, cyclical stocks – especially with smaller businesses – can see enormous swings, which may put some investors off.
For investors who are willing to put the time in to follow market trends and who are prepared to make regular tweaks to their portfolio, it can be easy to see why cyclical stocks are popular. However, it is down to you to decide whether they suit your investing style and risk profile.
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