The Prudent Investor Blog

The Prudent Investor - 2 Economic Realities for Investing

Posted by Benjamin Coakley on Mon, Aug 20, 2012 @ 08:32 AM

Our common sense tells us that we have to base our investment program on reality to beprudent investors successful.  In philosophy, our worldview contains our most basic assumptions about the world and the things we accept as true about the world.  The practical decisions we make everyday flow from our worldview.  The starting place for a prudent investor to judge investments, financial advice and financial advisors is economic reality. 

The prudent investor knows that every financial decision we make is about the future.  Our judgment about planning or investment options forces us to make assumptions about the economy.  We cannot evaluate plans or investments without making economic assumptions.  Typically, these assumptions are predictions or forecasts about what the economy is going to do.  If the assumptions are wrong, all the reasoning and conclusions based on those assumptions will be wrong.  This is basic logic.   

  • Noone can accurately predict the economy

If noone can accurately predict the economy, accurately predicting the component parts of the economy such as interest rates, inflation rates, stock market prices, real estate prices or what the price of a gallon of gas will be next week is not possible.  It also means that noone can accurately predict the component sectors of the stock market or the sectors of the economy: Telecom, Utilities, Materials, Consumer Discretionary, Consumer Staples, Industrials, Health Care, Energy, Financial or Technology.  Tomorrow, there will be new news and the market value will change. This is economic reality. 

  • You do not have to forecast the future to have a successful investment portfolio

Prudent investors can diversify with a portfolio of index funds or passive investments invests in all sections of the economy.  This will create diversification between asset classes (i.e. fixed income and equities, domestic and international stocks, large and small stocks and between growth and value stocks).  Diversification accross asset classes accounts for over 90% of the returns of an investment portfolio.  Most investors spend 90% of their time with market predictions, forecasts, stock picking and market timing when the value added to the portfolio is minimal at best.  In comparison, prudent investors spend 90% of their time on the asset class factors, the factors that impact an investment portfolio the most.

Tags: prudent investor, uncertainty, investing