Investors should give up trying to make decisions based on macroeconomic forecasts.
This advice may run counter to the investment culture created by major news outlets, but consider the alternative: An investor must identify the correct macroeconomic forecast, of which there are many, and then make the correct investment selections, of which there are also many. Even the most highly trained economists frequently misinterpret macroeconomic data.
Chances are slim that investors will do better. Instead, investors should understand the fundamental realities presented in microeconomic theory. It is a subtler and more established science with far fewer drawbacks than macroeconomics. As a result, there is much less potential for significant investment error.
- It is advised to ignore macroeconomic forecasts when making investment decisions as it is a difficult task and there is no widespread agreement on the conclusions drawn from it.
- Rather, individuals should make investment decisions based on the fundamental realities presented in microeconomic theory.
- Microeconomic analysis is largely based on logic and shows how prices help coordinate human activity toward an equilibrium point.
- Macroeconomics attempts to measure economy-wide phenomena, primarily through aggregated statistics and econometric correlations.
Micro vs. Macro: Two Kinds of Economics
Most economists, though certainly not all of them, believe different methods are needed for studying individual markets versus the whole economy. The modern distinction between microeconomics and macroeconomics is not even 100 years old, and the terms were probably originally borrowed from physics.
Physicists separate microscopic, or atomic, physics from molar physics, or what can be perceived by human senses. The idea is that microscopic physics describes how the world really is, but molar physics is a useful shorthand and heuristic device.
However, economics handles the distinction almost in the opposite fashion. Even though most economists agree on the basic tenets of microeconomic analysis, the field of macroeconomics grew out of dissatisfaction with perceived limitations in the predicted outcomes from microeconomics. There is no widespread agreement on the conclusions drawn from macroeconomic studies. Therefore, it is not shorthand for microeconomic truths.
How Each Field Works
Microeconomics concerns itself with single households, firms, or industries. It measures the intersection of supply and demand in these narrow ranges and essentially ignores other factors to better understand real relationships. Often presented graphically, a microeconomic analysis is largely based on logic and shows how prices help coordinate human activity toward an equilibrium point.
Because investors make their own individual choices, microeconomics is particularly applicable to investing because it studies how individuals make choices related to changes in certain variables, such as prices and resources.
Macroeconomics proceeds in a very different manner. It attempts to measure economy-wide phenomena, primarily through aggregated statistics and econometric correlations.
In microeconomics, for instance, complicating variables are often held constant to isolate how actors respond to specific changes. This shifts in macroeconomics, where historical data is first collected and then examined for themes of unexpected outcomes. This requires a massive amount of knowledge to be done correctly, and in some cases, macroeconomists do not even have the necessary tools for measurement.
Investors Need Micro, Not Macro
Microeconomics covers specific regulatory changes and competitive pressures.
By contrast, it is not even clear if investors need macroeconomics to make good decisions. Warren Buffett, the legendary investor, does not pay attention to economists or macroeconomics. He has said, "I don't pay attention to what economists say, frankly."
"You cannot get rich with a weather vane," Buffet said, regarding to macroeconomics in a meeting in 1994. Not every investor or fund manager would agree with this sentiment, but it is telling when such a prominent figure confidently disregards the entire science.
An economy is an extremely complex and dynamic system. To borrow terms from electrical engineering, it is difficult to identify real signals in macroeconomics because the data is noisy. Macroeconomists frequently disagree about how to measure effectiveness or how to make predictions. Some new economist is always popping up with a different interpretation or spin. This makes it easy for investors to draw incorrect conclusions or even adopt contradictory indicators.
Investors Should Be Cautious
Investors should study basic economics, though the limitations of the field present ample opportunities to be led astray. Economists often present information in a definitive manner to sound authoritative or scientific, but most economists make poor predictions. However, this does not prevent them from making more bold proclamations, each about topics with a lot of uncertainty.
Investors should demonstrate more humility, and this is where microeconomics can really help. It is not useful to try to predict where the S&P 500 will be in 12 months or what the inflation rate in China will be at that time. But investors can try to find companies with products that demonstrate a low price elasticity of demand, or identify which industries are most reliant on low oil prices or require high capital expenditures to survive.
Most investors buy corporate equity or debt, either directly or through a fund. Microeconomics can help identify which corporations are most likely to use their resources efficiently and generate higher returns, and the tools of analysis are easy to understand.
The Bottom Line
Macroeconomics may be more ambitious, but so far it has a much worse track record than microeconomics. Microeconomics provides the tools that allow investors to analyze the fundamentals of the securities in which they would like to invest in. This provides a clearer picture of how an investment may move, as opposed to the noise generated in macroeconomics and the disagreements on its aspects by economists.