When people think of macro investing they tend to think of Paul Tudor Jones, George Soros or Ray Dalio. These investors are using big macro trends to actively trade the markets. And while these strategies might work for some they will fail for most, in large part because they ignore the most important lessons from macro. Let me explain.
Macroeconomics is the study of aggregate economies or large components of the economy. When we apply this to finance and investing the study of aggregates is especially useful because you can properly understand what “the market” is and more importantly, you can better understand the economic effects of trading the aggregate market.
The absolute most important takeaway from studying the aggregate markets is that the market is hard to beat because we all collectively own the market and by definition, the average investor must underperform the market after taxes and fees. So, the more active you are the more taxes and fees you churn up and the less likely you are to outperform the market. This is why indexing works in a nutshell. It’s a very low cost and tax efficient way to get access to a diversified portfolio.
And that’s the second big takeaway from understanding macroeconomic investing – diversification works. Diversification works for many reasons, but the main reason it works is because, at an aggregate level, we collectively own all securities outstanding. Those securities are issued with specific purposes to meet specific needs across time. You don’t only diversify because it reduces single entity risk. You diversify because it helps you better understand how stable your cash flows will be over time. And that is the primary thing investors want – certainty. Sure, we all want to own the highest earning stocks with the least amount of negative volatility, but we also know that negative volatility is part of the tradeoff for higher returns. And by adding in cash, T-bills, bonds or other assets you can reduce the aggregate volatility and uncertainty of your cash flows. Diversification isn’t just a risk reducer in some textbook theoretical concept, it’s a sleep well tool.
The third big takeaway from understanding macroeconomics is that macroeconomic trends are inherently long-term. It takes years and decades for economies to grow, contract, grow and grow. People who use macro trends to make short-term trades are trying to squeeze blood from a stone. Stocks, for instance, are inherently long-term instruments that earn cash flows over many decades. The average firm takes 8-10 years to go public from inception. 80%+ plus of firms will fail before that even happens. So the firms we own within stock indices are firms that have been growing and accruing cash flows for a very long time. Bonds are even more straight forward. The average bond in a total market fund is about 8 years. It will take 8 years for that entire fund to turnover. So, no matter how much you trade that instrument you cannot mathematically make it earn more than it’s designed to earn over a specified period. And in fact, the more you trade it within the 8 year time period the more you’ll just churn up taxes and fees that reduce your average return. At the same time, you might have components of your portfolio that are inherently short-term (such as cash or T-Bills), but in the aggregate your portfolio will likely have a time horizon of 5, 10 or 20 years. That’s just the nature of the instruments inside any diversified portfolio.
Most people don’t think like this. Most of us judge stocks and bonds by the day, month or minute which is the equivalent of trying to make a plant grow by watching it. Don’t get me wrong. I did the same thing for a long time. I still get the urge to do it sometimes. It’s just human nature to think short-term because, well, life is short. And there’s nothing wrong with being informed or watching financial TV. In fact, a lot of what I write about is debunking macroeconomic narratives. I spent most of the 2010’s writing articles debunking macroeconomic myths. Which is quite useful because there are so many bad macro narratives that staying informed can help you avoid big pitfalls. So, in a weird way, staying more informed can help you behave better by helping you avoid getting the urge to (over)react to every short-term scary narrative you read.
And if you spend too much time on the internet you’ll inevitably run across macro “experts” who are doing all the opposite things described above. They are charging high fees, concentrating bets and trying to beat the market. But the reality is that the firm that best implements all these macroeconomic principles is the firm most people don’t think of as a macro firm – Vanguard. In fact, I’d argue that indexing style strategies are the absolute best way to implement macro approaches. Now, there are lots of ways to build an index and you might even use macroeconomic understandings to construct that index. But at the end of the day a good macroeconomic investing approach should always adhere to those big three principles.
In short, if you want to be a great macro investor think more like Vanguard and less like George Soros.