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A common misconception about investing is that the economy and the stock market are perfectly correlated



Peter Westaway, Chief Economist at Vanguard Asset Management, explains the connections and the differences

RP: One of the most common misconceptions about investing is that the economy and the stock market are perfectly correlated. Yes, they are connected, but it’s not that simple. Peter Westaway is Chief Economist at Vanguard Asset Management.

PW: Well, there are connections between economic growth and the stock markets but those connections aren’t as obvious and automated as you might necessarily think. For example, if you look at the countries with fasted GDP growth, they’re not necessarily the ones with fastest stock market growth. Where there is a connection though, is when you get an unexpected shock to a particular country’s GDP. So if say UK GDP suddenly comes out more strongly than people were expecting, what you expect to see is a surge in the stock market. In other words, the existing growth is already reflected in the price. So the fact that China grows more quickly than the UK should already be reflected in the stock markets.

RP: So, it’s shocks that cause price movements.. and, by their very nature, shocks are unexpected.

PW: It’s very much about, can you predict what’s going to happen, better than everybody else, before it happens. Because if you can, and predict and position your portfolio accordingly, you will then benefit from the surge in the stock market. But of course, it’s really difficult to systematically be better at predicting what’s going to happen in the economy than everybody else.

RP: As Peter explained, it doesn't always follow that high-growth economies generate the highest stock returns.

But often they do.Why should that be?

PW: It’s the case that countries like India, a lot of emerging markets, may tend to generate better stock market returns. But as much as anything, that’s because those countries are more risky. So, you will get periods when growth is strong and that will be reflected in strong stock market growth. But, often performance in those economies is very volatile. And so, investors need a reward for that extra degree of uncertainty, that maybe isn’t so much the case with a country like the US for example. That’s really where it’s going, it’s a reward for risk for investing in riskier markets.

RP: How useful is it, then, for investors to have a knowledge of economics? Actually, not particularly useful at all.

PW: For many investors, especially investors who have a long-term horizon. I think it’s important and reassuring to understand what the economic backdrop is. But, to then use that information to try to second-guess everybody else and to try and eek that extra bit of return out of their portfolios is really a bit of a fools errand. One of the things that I say a lot to investors is that I spend all of my time looking at these issues but I wouldn’t like to claim that I could systematically beat the market because of my insights.

RP: So, if even a distinguished economist like Peter Westaway admits he doesn’t have a market edge, the chances that you don’t either.

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