Investing or Betting?
At some time you have heard investing being equated with gambling. While even
the best gamblers count on a certain amount of sure things, they know there are
always uncontrollable factors that ultimately determine the outcome. Investing
has its own set of crap shots, particularly when investing for the short-term.
In the short run, the direction and pace of economic activity often proves to
be unpredictable. Few, if any, investors or economists forecast the great
speedup in economic growth during the past decade, or the recession that we
are in now.
Why this uncertainty? Basically it is because so many variables influence
swings in business activity, and their relative impacts differ from one economic period to the
next. In contrast to the unpredictability of short-term economic moves, the
long-term outlook for business activity is quite certain: gross domestic product
will grow. So no problem is forever.
The short-term pattern of corporate profits is even more uncertain because
of: changing economic conditions (boom, recession, or something in between);
varying rates of overall inflation and swings in specific costs (like energy,
whose huge price increases are squeezing many companies' earnings now); and
competitive factors (such as the worldwide overcapacity in the auto and personal
computer industries that has pushed down selling prices and profit margins
sharply, as demand for those products has slackened in a
slowing economy). One fact about individual companies' performance is that there
are good, bad, and indifferent businesses, and firms in various industries
usually perform well, poorly, or so-so because of the basic characteristics of
Forecasting earnings per share is a crucial part of company analysis and even
in these days of "managed" earnings, that is hard to do accurately
when business conditions change, as they often do. In all but a few very stable
businesses, the conditions affecting profits can shift from one quarter to the
next, and one year to the next.
Investors did not see this when the U.S. economy was
experiencing unusually consistent, strong growth. Forecasting near-term earnings
was easy then, but as less favorable business
conditions have developed, predicting quarterly earnings has returned to its
normal degree of difficulty and there have been lots of negative surprises. Most
of these have caused red faces for analysts and sharp stock price declines. As
with the general economy, many variables influence short-term earnings and it is
often impossible to forecast the impact of all of them properly.
In another area of forecasting, it has proven virtually impossible to pick
the ultimate winners in new businesses, especially in the fast-moving, high-risk
sectors. Most frequently, in fact, the early leaders have fallen by
Although economic forces are much more powerful than political forces in our
self-correcting free market system, political factors can be influential at
times. But they are usually quite unpredictable.
It really is uncertain how the current bailouts
and future political forces will influence the
economy in the U.S. or most other countries. One area where government (supposedly a non-political sector of government)
plays an important role is management of monetary policy by the Federal Reserve
Board. Changes in interest rates and the availability of credit can have a major
short-term impact on the economy and the financial markets. Often the Fed's
moves can be predicted accurately, but there have been notable exceptions that
Over the long run (measured in decades), the stock market is usually very
predictable. As has been demonstrated many times, the long-term trend of stock
prices (both the overall market and most individual stocks) is upward, in close
parallel with the growth of earnings per share. That is as certain as anything
about equity investing, for the simple reason that most companies' earnings do
grow and the more money a business earns, the more it is worth.
But in the short term, stock prices are totally unpredictable, because shifts
in investor moods come quickly and they're very powerful, often carrying stock
prices to extremes. This is why focusing on valuation of stocks is so crucial.
Valuation measures investors' moods and can thus tell us where a stock is
located on the psychological spectrum. That, in turn, indicates what the
risk/reward potential of the stock is -- but not where it is going tomorrow, or
next week, or even next year.
The real gamble of investing is that random, totally unexpected event that
pops out of the blue and has, temporarily, a big impact on the stock market or a
sector of the market. Examples include the surge of inflation from 3% to 13% in
the 1970s (accompanied by similar increases in interest rates), the spurt of
interest rates to an unbelievable 10% in October 1987 (when inflation was only
3.5%), the Iraqi invasion of Kuwait in 1990, the Asian financial collapse in
1996, the jump in energy prices, the recent housing collapse and now add the random terrorist incident.
By definition, such events are unpredictable, but because we know they will
occur occasionally, we should be prepared for them by prudent portfolio
construction. We should also recognize that these shocks will not be fatal to
the sensible investor; they just have to be waited out.
When one looks at all the factors influencing investment performance, it is
clear that a great many are unpredictable. But, in most cases, these relate to
the short term, while the predictable forces are generally long-term in nature.
And they have the greatest influence on ultimate investment success. Many
investors, especially inexperienced ones, worry a lot about "confusing
outlooks" and, therefore, expend far too much energy in fruitless attempts
to forecast the unknown. Once we can admit what we do not know and understand,
we admit that uncertainty is part of investing, we can then focus our attention
on what we do know. This will not always provide the right answer, but it will
increase our odds of success, and it will avoid the anxiety that occurs when
forecasts of the unknown prove wrong.