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September 19, 2003

Is Investing Like Buying a New Car?
by Tom Madell

Many people may subconsciously think of successful investing as quite a bit like buying a new car. Certainly, there are some similarities. Purchasing a new vehicle involves a big layout of money and so you want to be as sure as you can that you will make the right choice. And since you probably plan to rely on that vehicle for many years, you are motivated to carefully compare the various models and features available in arriving at your decision. But once your choice is made, you usually anticipate sitting back in the years that follow and enjoying what your effort has brought you, confident that your one-time choice was the right one.

So, wouldnt it be great if we could apply the same formula to our investing? After doing our initial legwork to select our investments, we could then turn our attention away from these decisions, confident that our one-time choices were the best possible, and capable of delivering the returns that we are hoping for without any further effort on our part.

Obviously, it would make life a lot easier if our one-time choices of investments was all that was necessary to 'deliver the goods' such as in the car purchasing example. In today's hectic world, where every hour available can seem to be a precious commodity, there are also several additional considerations which tend to reinforce 'the simpler is better' approach to dealing with one's investments.

First, there has been the move toward indexing. Here, the rationale is that no one can consistently beat the market averages, and given this, that no 'active' strategy appears makes sense other than just holding a representative basket of investments. Second, and closely related, we have all seen time and again how the experts and active fund managers themselves, with all their research and data, have typically underperformed rather than beaten the markets. Reasonable conclusion: 'If even these guys can't effectively use data to beat the markets, what chance do I have? I am better off just holding on to my investments, for better or for worse, rather than trying to periodically take current data into consideration in an effort to improve investment results.'

Last but not least, since most of us in reality don't seem to have the time (or perhaps rather the desire) to follow some of the factors affecting our investments: We reduce our mental stress, or what psychologists call 'dissonance', by adopting the belief that trying to manage your investments doesn't work anyway. And so we subconsciously convince ourselves we are actually acting smartly by not paying much attention to them. To allow ourselves to believe otherwise would be to suggest that we are perhaps acting negligently, putting our money (and maybe even our ability to successfully retire) at risk.

Yet in spite of the aforementioned use of various types of data, it seems that economists and analysts are too frequently off the mark when attempting to forecast the short to intermediate direction of the economy and its resulting impact on asset prices. Why, and what does this mean for us as ordinary investors?

While there are undoubtedly relationships between key ongoing economic data and the performance of many types of investments, many times by the time the data is measured and reported, it is apparent that asset prices have already adjusted in anticipation of the release. This serves to greatly diminish the predictive value of any given economic statistic.

For example, stock prices usually react positively to a expansion in growth, that is, gross domestic product (GDP). However, by the time the GDP statistic is reported, and then updated, well after the end of each calendar quarter, stocks may have already moved up. (This has been the case recently.) Since GDP is made up of a number of components, some reported sooner than the overall statistic, some investors are 'jumping the gun', often correctly estimating the final number prior to its release. These investors act early on this information, and move asset prices as a result. The element of 'surprise' when the statistic is finally released, then, rather than the absolute magnitude of the statistic itself may be the major factor to move asset prices during the period after its release.

Further, multiple instances of the data are often required to reliably elicit a predictive relationship with asset prices. This is due to the fact that a single measurement may be too tentative. A trend offering several confirmations is usually a more effective forecaster since 'statistical blips' up or down can occur which carry little significance for long-term asset prices. This confirmation may effectively take too long, diminishing its predictive use, while in the interim, new readings may fail to support it. As a result, important factors as for example inflation and interest rates, while reliably affecting asset prices, may only do so after an extended and unknown period of time. Thus, someone who invests in interest-sensitive stocks or bonds at the start of what later is confirmed to be a period of sustained rising interest rates may not suffer any ill effects for a while, but only after the trend is more clearly established.

What is the bottom line? Is there enough of a predictive advantage to justify at least minimally following ongoing economic data looking for the basic underlying trends? Yes, but you should keep the above limitations in mind. This is unless you are among those rare few investors who really never touch their investments or for whom the potential added performance truly isn't important.

But many people seem to be unsettled by the fact that some of data tends to be contradictory or doesn't appear to be working as predicted in the short term. They wrongfully conclude, I suspect, that most such data is essentially of minimal value and are no longer willing to spend their time seeking it out. It is far easier mentally for one to assume that a hardly perfect relationship simply does not matter than to be able to patiently await its likely outcome in spite of its frequent 'on again, off again' nature. But, for those who do track these relationships over the longer term, investing a minimal amount of time at it on a regular basis, I suggest they will find that the above kinds of relationships between economic data and subsequent investment outcomes are usually on target. And if acted upon to make periodic adjustments to your portfolio, this information can help to improve your investment performance over investors who do not put in this small amount of effort.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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