Math is at the heart of markets and economies, whether it is a simple budget or the rate calculation for a credit default swap. Physics has used math to make fundamental laws that help inform us about our universe and explain what we see around us. When one of these discoveries is important enough, it becomes a law. In this article, we'll look at what laws we can use to explain our financial universe.
- All Measurements Are Relative
Measurements only matter in reference to other events. A mutual fund returning 16% sounds good, but what if that year the market crawled up 14% normally? Earnings can fall 3% below analysts' expectations but still represent a 5% increase, or even exceed expectations simply by posting a lower-than-expected loss of 10%. (Learn how this key metric is calculated and how it is used to judge market performance Earnings Forecasts: A Primer.)
With the increasing tendency of Wall Street and the financial media to bombard investors with figures and attention-grabbing headlines like "XYZ smashes analysts expectations" or "ZYX tanks with a weak fourth quarter," it is important to realize that these figures may mean nothing for you. If an investor is happy with a company's fundamentals, then a quarterly loss or weak gain is just a small bump in a long road - it might even present a buying opportunity. (Learn more in What Are Fundamentals?)
In this same way, no benchmark is a universal measure, but is only useful in relation to what you're measuring. There is no point in measuring an aggressively managed fund against the S&P 500, because an aggressive fund should outpace the S&P in bull markets and underperform in bear markets. Instead, investors have to measure such things with benchmarks that are highly correlated – measuring an aggressive fund against all other aggressive funds – to get any meaningful information.
- The Future Is Unknowable
Analysts, market pundits and investors are firmly focused on the future. This is how we end up with companies trading at ridiculous multiples of their earnings – investors aren't paying for the company as it is, but as they see it performing in the future. Unfortunately, the future is unknowable and it gets increasingly so the farther ahead you try and look. This has three practical applications to the market:
- Your Portfolio
Sometimes value investors are given to hyperbole, suggesting that a good company can be bought, put in a drawer and forgotten for 20 years. While this may turn out to be true, it adds unnecessary risk to your portfolio. Because the future is uncertain, investors should check their holdings annually to see if there is any indication that the companies they own are changing for the worse. Black swan events that drain a portfolio can't always be avoided, but the long-term decline of a company shows up in the financials year-to-year. You can't predict the future, but you can look at the company you own now and decide whether you still want to own it next year. (Learn more in our Stock Picking Strategies Tutorial.)
Take analyst expectations with a large grain of salt. Following May Day, the business models for most brokerages changed from a focus on commissions to institutional banking services. This means that the age of the independent analyst is over. Instead, you have analysts writing reports for companies who are clients of their brokerage house, setting up a sizable conflict of interest. Analysts can be encouraged to predict a rosy future for a client even if their research suggests otherwise. This doesn't mean all analyst research is useless, but the recommendation pages with lofty predictions should be torn out before reading.
- Shooting Stars
Think hard before buying high P/E multiples. When companies start getting into the high 20s in P/E multiples it's essentially saying it will take two decades for you to make back your initial investment – that's if the company continues on exactly as it is. When investors buy into high multiples, they believe the company will continue to improve, paying back the investment and more in a much shorter time.
The odds are stacked against this as companies, even companies with a hot new product, generally follow a growth cycle where the fast-growth phase is only a small part. Even the most revolutionary products saturate the available market over time and profit growth slows. So, think twice before buying a company trading a 30 times earnings that might keep you waiting throughout your old age for the payout. It's fine to put risk capital on a few potential future giants, but you shouldn't leverage your whole portfolio on the future path of shooting stars. (Do you have the best mix of investments? Find out how to make sure, check out Major Blunders In Portfolio Construction and How Risky Is Your Portfolio?)
- Your Portfolio
- All Economies and Markets Are in Relative Motion
Einstein and others gave us a universe where galaxies are moving while also exerting forces on each other. In the financial universe, we have the economies of different countries expanding and contracting, and influencing the economies around them. Although we can say one economy is up compared to another, it's difficult to isolate one from the others. The amount of short-term capital in the world is relatively finite, and if one economy is seeing an increase, another economy will be experiencing a comparative lack.
The best part of this global market is that there will always be investment opportunities in some parts of the world, even if your domestic market is overvalued. Unfortunately, there is a downside to the mesh of forces making up global trade. If a speculative bubble dangerously accelerates certain parts of the global market, then the whole economic fabric can be warped. When the bubble bursts it leaves a black hole of destroyed capital like the mortgage meltdown or the crash of 1929. That said, the interaction of economies has brought far more prosperity than harm over thousands of years of trade. (For more, see 4 Factors That Shape Market Trends.)
Breaking the Laws of Physics
Although physics and economics both speak the language of math, there is one irreconcilable difference – human behavior can alter market laws, whereas we still haven't found a way to break the laws of physics. This means that observations, trading strategies and market theories may hold up for a long time and then suddenly fail. There are numerous incidents where groups, governments and even individuals have warped or suspended the natural functions of the market. This chaotic element of human behavior is what creates the risk and rewards that make investing as exciting as the black holes, particle smashers and quantum theories of physics.