Economics is something everyone has heard of, mostly when talking about money. It relates to money and the stock market, but it isn’t the study of those two things. But, it underlies every decision related to the money we make, including making investments. But how exactly does it tie into investing? Well, the economic way of thinking — rational choices, opportunity cost, etc. — certainly applies to investing and life in general. For example, the idea of opportunity cost applies to investing because of the comparison of different types of investments. Opportunity cost is what it sounds like: the cost of one decision/opportunity in comparison to another decision. But that is only the tip of the iceberg when it comes to applying economics within investing.
The Basics
A dictionary definition of economics is that it’s a “social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and services.” This basically means that economics is the study of human behavior with the need of fulfilling needs in a world of scarcity.
It’s no secret that there are a limited amount of resources in this world (and snapping half the universe out of existence doesn’t fix that, Thanos). Economics is about answering questions regarding how to use our scarce resources. It answers questions such as “what do we produce”, “how will we produce it” and for “who is the production for.” It is especially concerned with efficiency in production and trade and uses models and assumptions to understand how to create incentives and policies that will maximize efficiency. Maximizing efficiency is another way of saying that economics creates models that optimize the scarce resources we have to produce the optimal outcome.
Reflect on your past choices with your personal finances. How did you manage your money; how did you invest or spend it? Economists choose to explore why, for example, people decide to spend $159 on new Apple AirPods rather than save that money. The fundamentals of economics are to interpret the choices of individuals, businesses, and countries in a world of scarcity.
Macroeconomics and Microeconomics
In understanding economics, it is also important to recognize the difference between macroeconomics and microeconomics. Microeconomics is the area of economics that focuses on the decisions and interactions of individual actors, such as buyers, sellers or business owners. Microeconomics, for example, might put emphasis on a specific product, firm or industry. On the other hand, macroeconomics focuses on the bigger picture. This can mean either the economy as a whole, or aggregates, which is the grouping of many smaller economic units. Examples of macroeconomics might include national economies and economic indicators such as GDP and unemployment rates. Despite their differences, however, both macroeconomics and microeconomics are interdependent.
Rational Behavior
Rational behavior is the idea that humans act to optimize outcomes and maximize personal benefit. In other words, when given multiple options, people will always choose the option that provides them with the biggest economic incentive. Although the concept of rational behavior is important to understand since it forms the basis for many fundamental economic models and ideas, it can often be difficult to apply in the real world. Humans are impacted by a variety of different factors— ranging from cognitive to cultural— that cause them to behave irrationally. This overlap between the fields of economics and psychology forms the basis for behavioral economics.
Opportunity Cost
For instance, let’s say you have $10,000. You could leave that money in a savings account with 5% interest or invest in a stock. If you decide to invest in the stock and the stock returns 7% then you have benefited. However, if the stock returns 1%, then the opportunity cost would be the additional 4% you could have earned if you put your money in the savings account. This is why you have to be careful when investing in stocks and look at the risks and benefits in order to ensure that you will gain a profit from the stock. Opportunity cost is a cornerstone concept of economics, and something that applies to all decisions, whether personal or in the complex business world.
Positive and Normative Economics
Another distinction to be made is the difference between positive and normative statements in economic analysis. Positive economic statements center on factual evidence, while normative economics emphasize value judgments and how things ought to be. For instance, to say that the unemployment rate in America is lower than the unemployment rate in Spain would be a positive statement. Conversely, to declare that taxes in Norway are too high would be a normative statement.
Economics and Markets
From time to time, new policies and events will come and go. These new policies and events will affect the conditions of businesses and gives investors a tool.
The economic way of thinking is one tool. It helps investors analyze investment opportunities across all markets. The main connection between the economy and the stock market is the direct relationship between money and credit, and GDP and the stock market. Economists use past knowledge of the economy to map out economic indicators to study and support our present knowledge. These indicators can advise investors the current economic conditions and how markets will act.
A smart investor will not only look for quantitative factors but qualitative factors as well. Comparing a qualitative factor and a quantitative value can indicate whether an asset is undervalued or overvalued. This has led to the concept of market sentiment. Market sentiment is a gauge of the bullish, or optimistic, and bearish, or pessimistic, feelings of investors. However, when investors are euphorically bullish, investors should be cautious as that is a red flag for a bubble. A bubble refers to a market or sector that has extremely high and inflated prices that are unsustainable.
Check out this video for insights from someone who was extremely involved in tech during the dot-com bubble of the 90s. There also seems to be one brewing in China.
Key Takeaways
- Cash is a mode of trade; it permits individuals to acquire what they have to live.
- Dealing was one way that individuals traded merchandise for different products before cash was made.
- Macroeconomics is the part of financial matters that manages the structure, execution, conduct, and dynamic of the entire, or total, economy.
- As opposed to macroeconomics, microeconomics is progressively centered around the effects on and decisions made by singular entertainers in the economy (individuals, organizations, ventures, and so forth.).
- Humans are naturally inclined to make a “rational” choice; that is, to maximize their personal gain.
- When you make one decision, your opportunity cost is the amount of “utility” that you would have gained from the next best alternative.
Ultimately, the importance of understanding economics and its indicators is crucial for making investments. Having a basic understanding of economics will help you in making investment decisions both in markets and your life.
As legendary investor Howard Marks says, “Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is likely to be less than satisfactory” (The Most Important Thing. ix).
