Some industries are more susceptible to the ups and downs in the level of economic activity and prosperity compared to others. Such industries that do well during economic prosperity, and do badly when economic prosperity declines, are called “Cyclical” industries. On the other hand, industries that do well irrespective of whether there’s economic prosperity or decline are called “Non-Cyclical” industries.
Thus, cyclical industries are more dependent on consumers having higher disposable income, and do well when the consumers possess a higher sense of security about their jobs and incomes. Industries like automobiles, travel and leisure, airlines, luxury goods, home improvement, etc. are cyclical industries since they depend on the consumer having higher disposable income to spend on these non-essential items.
Non-cyclical industries like Discount Retail, Healthcare, Utilities, Food and Groceries, Household and Essential Consumer Products, etc. do well even in hard economic times since they provide products and services that people tend to spend on even in tough economic times. As they say, during tough economic times, a household goes to Walmart to get the basics, and they go even more to Walmart during good economic times since they have more to spend. So, a discount retailer like Walmart is not in a cyclical industry. Similary, a family will spend on electricity to light and heat their homes, irrespective whether the economic times are good or bad.
When constructing a portfolio of investments, you want to keep in mind whether the industry or business you’re investing in is a cyclical or non-cyclical business. A mix of cyclical and non-cyclical industries and businesses would ensure that you get a level of return irrespective of whether the economic times are good or bad, and additionally the cyclical businesses in your portfolio provide you an added return during economic prosperity. During economic prosperity, there’s only so much more electricity you can use in your home, which means you need a cyclical business that will perk up your return higher that what you would get by just having a non-cyclical business in your portfolio of investments.
This idea of cyclical and non-cyclical industries and businesses, and having a mix of them in your investment portfolio, also comes into play when you talk about diversification.
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