The Best Investors Know Their Limitations

The economy is so complex is it literally unknowable until you can look at it in the distant past. On TV, you’ll see commercials for mutual funds that say their managers understand economic complexity and are able to see how a rice shortage in India will mean greater demand for power line transmission in China. That’s a great marketing slogan, but sadly it’s not possible. There are trillions of moving parts in the economy reacting to each other every second, often in conflict to past reactions or without historical precedent. You’re better off paying attention to investing great Charlie Munger, who said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

One of the most harmful things an investor can do is pretend the economy, or the stock market, is simple and easy to understand. It causes one to see patterns that are actually random noise, and wrongly assume that if one lever is pulled over here, something predictable will happen over there. This is one reason uninterested passive investors often outperform professional ones. Uninterested investors aren’t tempted by to draw lines between two macroeconomic dots.

Take Munger’s advice; if you want to do well, don’t waste your time trying to be very intelligent. Forget searching for patterns and correlations you think might explain the future. Instead, avoid being stupid by realizing your limitations.

Here are two examples.

The economy and the stock market

If you ask the average investor where the stock market is going next, you’ll often get a “yes, it’s moving in this direction because…” Usually, these thoughts are predicated on the strength of the economy. But the economy isn’t necessarily tied to the markets. What the economy does today tells you nothing about what stocks might do tomorrow.

The correlation between current GDP growth and five-year subsequent stock returns is -0.06, this is pretty close to what you would expect were it random. Three-year forward-looking market returns aren’t much different, at -0.09. This goes counter to intuition. Most of us want to believe that market returns are driven by a strong economy and corporate profit growth. That’s true in the long-run, but the two don’t move in lock step. Markets are priced based on what people will think will happen in the future. Today’s reality is yesterday’s news. That’s why stocks surged in 2009 even though the economy was still a complete mess.

Economic data

Want to know what the economy is doing right now? Avoid initial economic reports, they will be revised so many times that the only thing we know for sure is that when issued, they are wrong. Take the monthly jobs report, one of the most anticipated numbers of the month. Each report is revised seven times after its initial release; twice in the following two months, and once a year for five years after that. Deutsche Bank recently tallied up all past revisions and found the average jobs report is revised up or down by 90,000 jobs, or nearly half the average initial number.

If the weather report told you that the temperature outside today will be 70 degrees, give or take 30 degrees, you would know it was a useless forecast, and you wouldn’t act on it. But investors often treat economic numbers as facts, and buy or sell based on the latest report. Remember, keep your actionable investment information limited to data that is clear, understandable, and places you in a position to prosper using the long-term movement of the economy and market. Ignore the short-term noise.

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