When the economy heads into a tailspin, you may hear reports of dropping housing starts, increased jobless claims and shrinking economic output. How does this affect us as investors? What do house building and shrinking output have to do with your portfolio? As you'll see, these indicators are part of a larger picture, which determines the strength of the economy and whether we are in a period of recession or expansion. (See also, "A Review Of Past Recessions.")

The Business Cycle

In order to understand the state of the economy at a given time, we need to start with the business cycle. Generally, the business cycle is made up of four different periods of activity, each of which can last for months or years.

Peak. At its peak, the economy is running at full steam. Employment is at or near maximum levels, real gross domestic product (GDP) is growing at a healthy rate and incomes are rising. Less encouragingly, prices tend to be rising due to inflation. Even so, most businesses, workers and investors are enjoying the boom times.

Recession. The old adage "what goes up must come down" applies perfectly here. After experiencing a great deal of growth and success, income and employment begin to decline due to any number of causes: an external event such as an invasion or a supply shock, a sudden correction in overheated asset prices, or a drop in consumer spending due to inflation – which in turn can lead firms to lay off employees. (Because the wages companies pay workers and the prices they charge consumers are "inelastic," or initially resistant to change, cutting payrolls is a common response). Rising unemployment pushes consumer spending down even further, setting off a vicious cycle of economic contraction. A recession is generally defined as two or more consecutive quarters of decline in real GDP. (See also, "9 Common Effects of Inflation.")

Trough. This is the section of the business cycle when output and employment bottom out. At this point spending and investment have cooled down significantly, pushing down prices and wages. This rebalancing makes new purchases attractive to consumers and new investments – in labor and assets – attractive to firms. 

Expansion (recovery). During a recovery – or "expansion," if we're not discussing it in the context of the last recession – the economy begins to grow again. As consumers spend more, firms increase their production, leading them to hire more workers. Competition for labor emerges, pushing up wages and putting more money in workers' (who are also consumers) pockets. That allows firms to charge more, sparking inflation that, while mild at first, may eventually bring growth to a halt and start the cycle over again. Over the long term, however, most economies tend to grow, with each peak reaching a higher high than the last.

Phases of the Business Cycle

This scheme is overly simplified, of course: economies sometimes experience double dip recessions, for example, in which a short recovery is followed by another recession. Nor do all economies enjoy a positive long-term growth path. The relationships among spending, prices, wages and production described above are also too simple: governments often have a large influence at all stages of the cycle. Excessive taxation, regulation or money-printing can spark a recession; fiscal and monetary stimulus can turn a shrinking economy around when the supposedly natural tendency to rebalance fails to materialize. (See also, "Industries That Thrive on Recession.")

What Does this Mean for Investors?

Understanding the business cycle doesn't matter much unless it improves portfolio returns. What's an investor to do during a recession? The answer depends on your situation and what type of investor you are. (See also, "Recession-Proof Your Portfolio.")

First, remember that a bear market does not mean there's no way to make money. Some investors take advantage of falling markets by short selling stocks, meaning they make money when share prices fall and lose money when they rise. This technique should only be used by sophisticated investors, however, due to its unique pitfalls. The most important of these is that losses from short selling are potentially infinite: there is no obvious limit to how far a stock's value can rise. (See also, "Short Selling Tutorial.")

Another breed of investor treats a recession like a sale at the local department store. Known as value investing, this technique looks at a declining share price as a bargain waiting to be scooped up. Betting that better times will eventually return in the economy, value investors take advantage of bear markets to pick up high-quality companies on the cheap.

There is yet another type of investor who barely flinches during recession. A follower of the long-term, buy-and-hold strategy knows that short-term problems will barely be a blip on the chart over a 20- to 30-year horizon.

Of course, few of us have the luxury of looking decades down the line, or the iron stomach required to do nothing in the face of huge paper losses. Value investing is not for everyone either, as it requires extensive research, while short selling calls for even tougher discipline than buying and holding. The key is to understand your situation and pick a style that works for you. For example, if you are close to retirement, the long-term approach definitely is not for you. Instead of being at the mercy of the stock market, diversify into other assets such as bonds, the money market and real estate.

The Bottom Line

Reading the headlines during a recession can convince you the sky is falling. But downturns are a normal part of the business cycle, and it's important to develop a strategy for dealing with them based on your financial situation and appetite for risk. (See also, "The Impact Of Recession On Businessesand "Profiting In A Post-Recession Economy.")