It should be quite obvious to anyone that economics have an effect on markets. Predictions about employment, GDP growth, inflation, fiscal and monetary policy, and trade balance, all have an effect on global enterprise and therefore have an effect on markets. What may not seem as obvious is that the two should not be seen as synonymous. Bad economic outcomes do not necessarily mean bad market outcomes and good economic outcomes do not necessarily mean good market outcomes. It is really a discussion of expectations and actuality.
This is probably one of the most important concepts for investors to grasp. Global markets are constantly digesting information in order to set fair prices. A fair price is defined as what a willing buyer and a willing seller agree on what is likely to benefit either party. In professional money management, two different individuals are making two different estimates about the future prospects of a particular company based on the economic data that has been provided to them. Based on the uncertainty and appetite for risk, one is willing to buy that proposition and one is looking to sell it. They will come together on exchanges in order to “exchange” that appetite for risk or uncertainty. This process is repeated millions of times a day across millions of investors to set expectations about the future. If reality turns out to be much different, then short-term volatility should be expected.
Of course we are not robots who are constantly making decisions based on data. Emotions can run rampant, especially during severe market turmoil, which usually happens when an unexpected event blindsides markets. Markets are not perfect nor do we describe them as being so. Nonetheless, they are still efficient in digesting both sound and emotional judgments to the point where it is hard for investors to decipher one from the other.
This process of setting fair prices based on uncertainty and appetite for risk is where the return from our diversified portfolios comes from. As passive investors, we piggyback on all of this activity and accept the risk and return the markets are setting every day because we know that trying to outguess it is a fool’s errand. Because the market represents the aggregate expectation, it will always know much more than any individual participant.
As economic data becomes available, markets digest them and set expectations about the future based on that data. If the market has determined that the future is more uncertain for global enterprise, prices will adjust to reflect the additional uncertainty. As a buyer of uncertainty, we would require to be compensated for shouldering that risk. If not, then nobody would participate in the market. It would be analogous to unexpectedly finding out that the home you are looking to purchase needs a new roof, but you are willing to pay the same price for the home anyway. It doesn’t make sense, right?
This is a constant process. During both good times and bad, markets are setting fair prices so you are expected to be compensated accordingly. If reality turns out to be worse than the market expectation, expect volatility to the downside. If better than expectation, expect volatility to the upside. So the next time you read a news story about the gloom and doom of the future of global enterprise, just know that markets have already digested it and reset prices so that you are still expected to have a positive return.
As always, our recommended approach is to buy, hold, and rebalance a portfolio of index funds that represent the global expectation of enterprise.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.