Friday, October 22, 2010

Investment Returns: Where Do They Come From?

The biggest problem with investment returns is that they're posted daily.

So what?  Well it implies that what happened yesterday means something for your financial future.  People spend hours poring over last week's investment returns while the cable channels and newsletters feed the confusion by trying to explain yesterday's downturn in terms of this or that event or trend.

If this cascade of information and shouting confuses you, never fear, it confuses everyone because the short term noise is just that:  noise.  It has no meaning for the disciplined investor.

To keep from pulling your hair out at all of the short term fluctuations, you need to remember that at all times, there are three forces driving financial markets.  The first is long-term economic growth.  Global businesses are gradually expanding their operations, opening up new markets, learning to manufacture and serve their customers more efficiently, creating new products.  With billions of new customers emerging in India, China, Indonesia and elsewhere, and new technology improving the efficiency of doing virtually everything, historically, this trend has been upward since people first squatted in caves to admire cousin Zog’s first invention:  fire.

The industrial revolution, the information revolution, and whatever new revolution the Internet and iPhone are a part of are accelerating this long-term business trend.

The second force is the economic cycle, which moves from exuberant growth to panic to renewed growth in an unpredictable but inevitable cycle.  Economists have felled whole forests trying to forecast these gyrations without because they embed the decisions of billions of consumers and investors.  But most of us recognize the feeling of excitement and then becoming overextended, panic and pulling back that characterizes our lives.  Nothing goes in a straight line.

The most important thing to realize about economic cycles is that they fluctuate around the longer term upward trend.  Historically, highs have tended to be higher than the previous one, although that’s not always the case.

The third force is investor emotions, which are by far the most volatile element of investment returns, and can change hourly, daily, weekly, monthly.  You know these on a personal level; it's what you feel when you see the market go freefall.  Normally markets are like a day tripper’s fishing vessel: the number of buyers and sellers is roughly in balance, just as the number of fishermen fishing off of each side is.  But let a whale pop into view on the port side and all the fishermen rush to over – if they do so quickly enough, they push the boat far over on its side.  Investing has the same phenomenon:  shocking new information causes everyone to run to the sell or buy side of the market, tipping the markets deeply for a short period until it rights itself and gets back into balance.

But that's the point: studying the waves, studying what happened yesterday or last quarter, tells you nothing at all about the long-term viability, health or growth of the companies in your investment portfolio--despite what the talking heads happen to be screaming today.  You might get equally-valid information looking at the patterns of tea leaves or the markings on the back of that whale.

That doesn't mean the waves have no impact on investments, however.  The great investors, like Warren Buffett, look for those times when a billion investors are pushing the panic button, and take advantage of stocks selling at bargain prices.  Thousands, perhaps millions of investors had to sell during a lot of panics to make Warren Buffett a billionaire, and in his annual shareholder meetings, he acknowledges this.  The waves go in the opposite direction as well, taking prices well out of the bargain zone.

Through it all, the long-term trend is quietly making you money, moving us toward a future day when people will look back at us the way we look back at people who lived at the dawn of the Industrial Revolution.  They will wonder how we could get so excited about all these little ups and downs while the economy was steadily, visibly, reliably carrying us to a better place.

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