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.
Economics: What Is It?
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 was created to help us answer questions regarding how to optimize decisions and production with the scarce resources we have. 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 it? How much did you invest? How much did you spend? Economists are intrigued by your decisions and 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. Microeconomics deals with the economics of individuals and businesses. Macroeconomics deals with the economics of whole countries and governments.
The Influence of Economics
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.
- 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.).
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).