What is cyclical risk?
When you make an investment, there's a risk it could be adversely affected by the economic cycle. This may be because the investment was poorly placed to withstand an economic slowdown or that it was unsuitable for an economic boom.
Where have you heard about cyclical risk?
At the time of the UK's Brexit vote in 2016, the Bank of England generated a £150 billion 'counter-cyclical capital buffer' to assist during financial downturns. This shows the dangers of the economic cycle and of cyclical risk money from phases of expansion needs to be saved to counter risks in a contraction.
What you need to know about cyclical risk...
The economic cycle includes a period of expansion and then contraction. While this cycle is fairly consistent, with each cycle lasting around 6 years, some investments can be impacted negatively by the cycle.
Imagine a company whose share price and net earnings directly correlate to the economic cycle – this is a cyclical company. In an upswing, cyclical stocks would usually include those in companies involved in property, travel, cars, consumer electronics, commodities and mining. In a downswing, the cyclical stocks would be in companies involved in products and services that have to be bought regardless of the economic weather. These include food, clothing and utilities.
Cyclical risk describes the danger of having the wrong stock selection for a particular part of the cycle.