Macroeconomic Risk
Markets often act like living people with personalities. Many investors anthropomorphize the market, lovingly referring to it as “Mr. Market.” If we look at securities markets as a person, then any competent psychologist would diagnose this person with Borderline Personality Disorder (BPD). People with BPD, originally thought to be at the “border” of psychosis and neurosis, suffer from difficulties with emotion regulation. BPD sufferers may form an immediate attachment, exalt another person, but quickly and without warning switch to the other extreme, and angrily accuse the other person of not caring for them at all. Similarly, Mr. Market can go along for periods as your best friend, and then turn on you without warning.
When Mr. Market turns against you, the results can be devastating and cause long-term harm. I am happy to report that the securities markets are not a person, and they do not have emotions to regulate. They are a product of economic forces that can be predicted and taken into account in your portfolio management strategy. I am not at all suggesting that you can time the market based on these strategies. Do not try it. I am suggesting that cyclical shifts in economic conditions can cause havoc, or they can be a minor inconvenience, depending on how you prepare for them.
Macroeconomics is the subfield of economics dealing with large-scale or general economic factors, such as interest rates and national productivity. When it comes to investing, many retail investors make the mistake of thinking about a particular type of security that they favor. Stock investors may have some concept of how inflation affects stock prices, but they are often clueless as to the effects on bonds and cash. If you have an understanding of these forces and how they can influence a diversified portfolio, then you can protect yourself from periods of “bad” economic conditions.
It is important to understand that different types of investments behave differently under different economic conditions. Under certain conditions, cash may actually be a good place to be (even though we haven’t seen such conditions in a very long time). At other times, certain types of bonds may be your best bet for making a decent return. Under still different conditions, stocks may be the smart investment. The balance of this section will provide an overview of the most important economic conditions and how those varying conditions influence the return of different investment types. I will conclude that you can’t time markets, you can’t outsmart them, and so your best option is to build your portfolio around Murphy’s Law and assume that all possible outcomes will happen to you at some point, and when you least expect them.