How Long-Term Returns Are Shaped by Financial Cycles

Investors who think the present will last forever are often humbled by markets. Easy money eras seem to last forever—until they don’t. While downturns provide the impression that opportunity has permanently disappeared, booms persuade investors that risk has disappeared. However, history demonstrates that neither extreme is sustainable.

The underlying rhythm of financial cycles is what endures. Recognizing how capital and returns behave over time and applying that understanding to create long-lasting and sustainable results is the goal of understanding these cycles, not forecasting the next crisis or rally.

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What Are Financial Cycles?

Recurring trends in investment behavior and economic growth are known as financial cycles. Financial cycles are typically longer and have a greater impact on asset returns while being frequently mistaken for business cycles. They are mostly influenced by risk appetite and credit expansion and contraction.

Borrowing is made easier and optimism grows during expansionary periods. Investors’ risk tolerance grows as capital flows freely. Excess eventually accumulates in the form of mispriced assets, excessive debt, and exaggerated expectations. As a result, credit tightens and risk is repriced during a correction or contraction phase.

Years or even decades may pass throughout these cycles. Crucially, they influence not only transient market fluctuations but also the long-term profits that investors eventually realize.

Why Most Investors Don’t See How Important Timing Is

It’s common to define long-term investment as a straightforward exercise: purchase and hold high-quality assets. Although there is value in this principle, it overlooks a crucial factor: the entry point. Future results might be significantly impacted by the financial cycle an investment enters.

Years of muted or even negative real returns are frequently the result of making aggressive investments at the top of a cycle when valuations and optimism peak. On the other hand, capital deployment during times of pessimism and tight financial conditions has produced disproportionate long-term profits.

This does not imply that investors need to time the market precisely. Instead, it emphasizes the significance of capital discipline and understanding the position of the markets and economy within a larger financial cycle.

Interest Rates and Credit’s Function

Financial cycles are driven by interest rates. Borrowing increases consumption and asset inflation when interest rates are low and credit is plentiful. Growth assets like stocks and discretionary sectors which prosper when customers feel secure tend to profit from this atmosphere.

Think about the Australian stock market after the global financial crisis of 2008–2009. While investors who made large investments around the late 2007 market top suffered years of stagnation or negative returns, those who put their capital in banks and consumer discretionary industries near the bottom of the cycle experienced significant gains over the following ten years.

Similar to this, consumer discretionary spending has traditionally increased in New Zealand due to low interest rates and robust economic growth, with online platforms like Jackpot City New Zealand witnessing increased activity during these expansionary periods. Timing within a financial cycle can have a significant impact on long-term returns, as demonstrated by commodity cycles driven by China’s industrial demand and interest rate variations on a global scale.

On the other hand, low interest rates also promote leverage. The system becomes fragile if debt levels increase more quickly than incomes or cash flows over time. The cost of capital rises as central banks tighten policy or inflation appears. Risk assets are reevaluated as assets that prospered on cheap money start to change.

Behaviors That Intensify Cycles

Financial cycles have a strong psychological component in addition to being strictly mechanical. Both booms and crashes are amplified by human behavior. Investors are motivated by fear to sell excellent assets at discounted prices during downturns while greed encourages them to seek performance close to cycle peaks.

Investors tend to overestimate the endurance of current conditions due to recency bias which is the propensity to project recent patterns into the future. Bull markets make risk seem low. It seems hard to recover in bear markets. In actuality, cycles change at the exact moment when everyone is most certain they won’t.

Investors who are aware of these behavioral pitfalls are in a better position to behave sensibly during periods of elevated emotion. Over time, avoiding big mistakes may become as crucial as figuring out whether investments are profitable.