Recessions and expansions are normal phases of a business cycle in modern free-market economies. A recession occurs when the economy stops growing – instead, it contracts. This happens from time to time – the economy grows in fits and starts. The normal state of an economy is expansion (i.e. growth in GDP). Recessions happen infrequently and cause decline in GDP.
Causes of each recession tend to be unique – sometimes it’s government policies like taxes and interest rates. Other times, external factors like wars, droughts, natural or man-made disasters, etc. On occasions, it’s caused by excessive speculation and over-investments by individuals or businesses. Part of the reason why recessions are so difficult to predict is that there is no one factor that would always cause a recession.
– R. Mark Rogers, “The Complete Idiot’s Guide to Economic Indicators”
Most of the time, the economy is in expansion i.e. GDP is growing. Occasionally, it goes into a contraction (a.k.a. recession) that last 1-2 years. Expansions are generally much longer affairs – lasting anywhere from 4 to 10 years at a time.
Even during recessions, the economy does not, of course, ground to a halt. It just contracts a bit. For instance, in the US, the GDP tends to drop 1% to 3% (year-over-year) during a recession. Very rarely, it drops as much as 4%. The following two charts show how the US GDP steadily grew over the years (with occasional hiccups) and its annual growth rate.
During the Great Recession (2008-2009), the US GDP dropped from $14,843B to $14,340B – or about 3.4%. The economic machine was still humming – albeit a bit slower.
Most previous recessions are not even that big. After all, they didn’t add the qualifier “Great” to this “Recession” for no reason! And yet if you read the media headlines from late 2008, you might be justified in thinking that the entire economy had come to a grinding halt.
As an investor, you’d be better off ignoring any prognostications by the mainstream media. You don’t know how good that journalist is (or the experts he quoted). It’s better to read (or listen to) the opinions of investors who have successful long-term records. People like Warren Buffett, for instance, who predicted on the cusp of the Great Recession that the economy will do just fine over the next 10 years.
– Warren Buffett in October 2008
A recession is not a long-term catastrophe. Think of the US economy as a gigantic flywheel. It’s been spinning since the birth of the nation – producing economic activity that we formally call GDP. Goods and services produced and consumed by people and businesses. Most of the time this flywheel is gradually picking up speed as it turns (GDP growth). Occasionally some external factor cause this wheel to decelerate a bit. But the flywheel is very large and moving quite rapidly. It can be made to slow down somewhat but it takes a large opposite force to do it. It doesn’t stop ever. It can’t stop. Can you imagine people would stop buying groceries, heating their homes, driving to work, going to a doctor, buying clothes, etc.? Would businesses stop running factories, paying workers their salaries, providing services to clients?
The economic flywheel slows down during a recession but it inevitably picks up again. For us long-term minded savers, recession is a mere blip on our investing radar!
We should view recessions as opportunities – not catastrophes. The stock market will surely fall when the next recession hits our economy. Can we try to get ahead of the next down-cycle? No, because we cannot reliably predict a recession. In fact, recessions are near-impossible to predict – even for economists and researchers.
The best course of action for us investors is to stay invested. When the stock market falls during the next recession, we will have the opportunity to pick up stocks on the cheap.
Before we know it, a recession will yield to a new expansion – as it always does. And we will be on our way to financial independence!
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