CYCLICAL RISK

The risk of business cycles or other economic cycles adversely affecting the returns of an investment, an asset class or an individual company’s profits. Cyclical risks exist because the broad economy has been shown to move in cycles – periods of peak performance followed by a downturn, then a trough of low activity. Between the peak and trough of a business or other economic cycle, investments may fall in value to reflect the uncertainty surrounding future returns as compared with the recent past.

Cyclical risk can also be tied to inflationary risks, as some investors consider inflation to be cyclical in nature.

Cyclical risk does not typically have a tangible measure, but instead is reflected in the prices or valuations of assets that are deemed to have higher or lower cyclical risks than the market. For example, certain stocks are considered cyclical because company net earnings tend to rise and fall with the business cycle and may be volatile from peak to trough.

These stocks will typically sell off (fall in price) when the economy first shows signs of a slowdown, and therefore earnings valuations will fall compared to the broad market. Conversely, cyclical stocks will typically rise faster than the broad market when the economy is coming out of the trough period of the business cycle, as these stocks are now seen as able to grow earnings faster in the near future.

Cyclical risk of inflation can be somewhat mitigated by purchasing inflation-protected securities or through the use of derivatives.