Tip #11: Avoid the Myth of GDP as a driver of stock markets
“Part of my problem is that I cannot dispel the myths that have somehow accumulated over the years. Somebody writes something, it's completely off the wall, but it gets filed and repeated until everyone believes it. For instance, I've read that I wear a football helmet in the car.” – Stanley Kubrick
Greek Mythology is packed with stories of love, betrayal, tragedy and triumph. From Clash of the Titans, to Prometheus and the Theft of Fire, and Theseus and the Minotaur it seems that Greek poets were highly intent on teaching us valuable lessons about life. Finance also has its share of myths, but unlike the enlightening and highly entertaining Greek myths, financial myths mostly lead to lower portfolio returns and even financial demise. Identifying these financial misconceptions can help you tune-out the noise and ultimately make better investment decisions than the so-called gods of Wall Street.
One of the most commonly publicized financial myths is that GDP (economic) growth drives stock market returns. Spreaders of this myth reason that higher GDP growth translates into higher company earnings, which results in higher equity returns. This has NOT been the case, however. In fact, statistical analysis of most markets shows no meaningful relationship between equity returns and GDP growth. That’s because stock markets are forward-looking and already compensate investors for expected future growth.
What really drives stock prices over the mid to long run is how/if company managers are able to generate cash flows, higher-quality earnings and an adequate return on equity (ROE) from their business activities – regardless of the economic circumstances. Another important driver of stock prices is if/how company managers return earnings to investors (i.e. in the form of dividends and stock buybacks) or whether they opt to use free cash flows to make smart reinvestments that will generate even more earnings growth. Finally, rather than GDP or other economic indicators, stock returns are also driven by idiosyncratic risk, which refers to inherent factors to an individual company that are extremely hard to control and can negatively impact it (i.e. management scandals, a new competitor entering the market, negative regulatory changes, etc.).
If these concepts seem a bit overwhelming and harder to understand than Greek mythology, don’t worry. For, even those well-versed in literature, have a difficult time getting through Homer’s Iliad. Likewise, not all investors instinctively grasp the forces driving stock price dynamics. What truly matters is that we all keep working at objective investing, asking tough questions, separating facts from fiction, questioning conventional wisdom, looking at data, and dispelling dangerous financial myths.
Ohhhh and there's some good news and relief for all of you brave investors out there... Although investing, like any heroic feat, will never be without risk, there is ONE (myth-free) way to reduce idiosyncratic risk and still come out on top: Establishing a diversified global portfolio.
For more on this subject, stay tuned for the next investment TIPS!
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