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Diversification Can Help Regulate Economic Shifts

As the U.S. economy continues to climb out of the depths of the Great Recession of 2007, some investments have outperformed others because different types of investments tend to react differently through the regular cycles of economic expansion and contraction. By diversifying assets across a broad mix of equities and fixed-income investments, you can position yourself to capture the natural ups and downs of the markets.

The economy tends to follow a recurring pattern of growth: it accelerates, moderates, slows and finally declines. Since 1945, the U.S. economy has experienced 12 recessions and 12 expansions, including the expansion we're in currently.1 Each phase of these cycles is associated with specific economic benchmarks, such as unemployment rates, growth of gross domestic product (GDP), inflation and interest rates. These fluctuating economic factors can impact how asset classes and various sectors, or groups of industries, perform.

Market Cycle Impacts on Investing

During the early-cycle phase, the economy is rapidly recovering from a recession. Companies that post robust profit and sales growth and stocks tend to have their strongest performance. Interest rates are low and consumer expectations are rising, which benefits consumer discretionary stocks — autos, appliances, clothing — and financial stocks. Industrials, information technology and materials also tend to do well in anticipation of greater spending by corporations and consumers. Bonds and cash generally experience their weakest returns.

In the mid-cycle phase, growth is more moderate and sectors such as technology and industrials shine. Once economic growth reaches its peak in the late-cycle phase, inflation rises and corporate profit margins drop. With a potential recession on the horizon, so-called defensive sectors that are in demand regardless of the state of the economy — such as healthcare, consumer staples, and utilities — become attractive. Stock performance is still strong, but market corrections often occur during this phase.

In the recession phase, consumer expectations have fallen, along with inflation and interest rates. Stock returns drop as bonds and cash outperform. Consumer staples, healthcare, telecommunications and utilities are the sectors that do best in a declining economy.

Choose Winning Investments

Some individuals try to time their investments by investing over- or under-weighting various sectors and asset classes in their portfolios to capitalize on expected gains as the economy moves through different phases of the market cycle. But the trajectory of the economy can be difficult to predict, and various shocks — such as natural disasters, political changes and geopolitical risks — can throw off a cycle off course. For long-term investors, the best approach is to maintain a diversified portfolio that provides exposure to all sectors and asset classes.

Meet with your retirement plan representative to review your portfolio and answer asset allocation questions.

1National Bureau of Economic Research, nber.org/cycles/cyclesmain.html


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