The Hidden Source of Returns

The biggest problem with investment returns is that they’re posted daily–or, in the case of the recent “flash crash”, every hour or so.

Why is this a problem? Because it implies that what happened yesterday or the day before is meaningful to your financial life and is important information for future investment decisions. People all over the world struggle with figuring out the relevance of last week’s, last month’s or last quarter’s investment returns. The cable investing channels and newspapers feed the confusion by trying to explain yesterday’s downturn in terms of housing or unemployment data; they project tomorrow’s returns based on interest rates and earnings reports. 

If you’re one of those people who checks the market regularly and can’t quite find the meaning in all this short-term information, then it’s time to relax. Because – there IS no meaning to be found there. There are three forces guiding the markets at all times. The first force is long-term economic growth. Global businesses are gradually expanding their operations, opening up new markets, learning to manufacture and service their customers more efficiently and creating new products. With billions of new customers emerging in India, China, Indonesia and elsewhere, and new technology improving the efficiency of building, tracking, servicing, managing and everything else, this trend has been moving generally upward since people first squatted in caves around a wonderful new invention called the campfire.

The industrial revolution, the information revolution, and whatever new revolution Web 2.0, the Internet and iPhone are a part of are accelerating this long-term business trend. It is invisibly growing your money if you can stay invested.

The second force is the economic cycle, which moves from robust growth back to recession back to robust growth in a round-trip gyration which can last anywhere from months to years. Economists have felled whole forests trying to explain the hows and whys of these fluctuations, but most of us instinctively understand what it means to become overextended, pulling back, tightening our belts and then moving forward again. No human activity can be graphed as a flat line.

The only important thing to realize about economic cycles is that they are generally subservient to the longer-term cycle. Throughout all the ups and downs and sideways movement, the world economy has experienced net long-term growth ever since those first campfires.

The third force is investor emotions, which are by far the most volatile element of investment returns. They can change hourly, daily, weekly, or monthly. You know these on a personal level; it’s what you feel when you see the market go into the “flash crash” freefall, or a year and a half ago when the markets suddenly realized that the demise of Lehman Brothers–a company which helped finance the Civil War–was a scary event. That urge you feel to sell everything and make the anxiety go away is shared by roughly a billion other investors around the globe. They all conspire, unconsciously but powerfully, to rock the markets like the ocean waves in a storm. Even on good days, these waves are rolling around powerfully enough to make TV analysts think they can find meaning in them.

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 Jim Cramer or any other financial showman happens to be screaming today. You might get equally-valid information looking at the patterns of tea leaves or the markings on the back of tortoise shells.

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 can 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 (or scream on TV about) all these little ups and downs while the economy was steadily, visibly, reliably carrying us to a better place.