Even the most highly experienced economists frequently misinterpret macroeconomic data. The chances are slim that an individual investor will do better.
This advice runs counter to the investment culture created by the financial news cycle, but consider the odds: An investor must identify the correct macroeconomic forecast, of which there are many, and then make the correct investment selections, of which there are also many.
Instead, investors should understand the fundamental realities presented in microeconomic theory. It is a subtler and more established science with far fewer drawbacks than macroeconomics. As a result, there is less potential for significant investment error.
- An economy is an extremely complex and dynamic system.
- Microeconomics focuses on the decision-making processes of individuals and companies in response to current economic factors.
- Macroeconomics draws its conclusions from broad economic data such as the direction of interest rates and the unemployment rate.
Micro vs. Macro: Two Kinds of Economics
Macroeconomics is the study of the overriding factors that affect an economy. Inflation, interest rate changes, and unemployment numbers are examples. Macroeconomists study the impact of changes in these factors on the overall economic health of a nation and attempt to predict their long-term effects.
Microeconomics zeroes in on the individual decision-making processes of individuals and businesses. It is closely linked to psychology in its focus on human behavior and what influences it.
This modern distinction between microeconomics and macroeconomics is not even 100 years old, and the terms were probably borrowed from physics.
Physicists separate microscopic, or atomic, physics from molar physics, or what can be perceived by human senses. The idea is that microscopic physics describes how the world really is, but molar physics is a useful shorthand and a heuristic device to use in problem-solving.
Economics almost reverses the distinctions between the two. Most economists agree on the basic tenets of microeconomic analysis, but the field of macroeconomics grew out of dissatisfaction with the limitations that were perceived in the predicted outcomes from microeconomics.
There is no widespread agreement on the conclusions drawn from macroeconomic studies. Therefore, it is not shorthand for microeconomic truths.
How Each Field Works
Microeconomics concerns itself with individual households, companies, and industries. It measures the intersection of supply and demand in these narrow ranges and essentially ignores other factors to better understand real relationships.
Often presented graphically, a microeconomic analysis is largely based on logic and shows how prices help coordinate human activity toward an equilibrium point.
Microeconomics is particularly applicable to individual investing. It studies how individuals make choices based on changes in certain variables, such as prices and resources. Investors, too, make their own choices,
Macroeconomics proceeds in a very different manner. It attempts to measure economy-wide phenomena, primarily through aggregated statistics and econometric correlations.
In microeconomics, for instance, complicating variables must often be held constant in order to isolate how actors respond to specific changes. However, in macroeconomics, historical data is collected and then examined for themes of unexpected outcomes.
Therefore, macroeconomics requires a massive amount of knowledge to be done correctly. In some cases, macroeconomists do not even have the necessary tools for measurement.
Investors Need Micro, Not Macro
It is not even clear if investors need macroeconomics to make good decisions. Warren Buffett, the legendary investor, does not pay attention to economists or macroeconomics. He has said, “I don’t pay attention to what economists say, frankly.”
“You cannot get rich with a weather vane,” Buffett once said regarding macroeconomics. Not every investor or fund manager would agree with this sentiment, but it is telling when such a prominent figure confidently disregards the entire science.
An economy is an extremely complex and dynamic system. To borrow terms from electrical engineering, it is difficult to identify real signals in macroeconomics because the data is noisy. Macroeconomists frequently disagree about how to measure effectiveness or how to make predictions. A new economist is always popping up with a different interpretation or spin.
This makes it easy for investors to draw incorrect conclusions or even adopt contradictory indicators.
Investors Should Be Cautious
Investors can benefit from studying basic economics, but the limitations of the field present ample opportunities to be led astray. Economists often present their conclusions in a definitive manner to sound authoritative or scientific, but most economists make poor predictions. This does not prevent them from later making more proclamations despite the fundamental uncertainty of their field.
Investors should demonstrate more humility than economists, and this is where microeconomics can really help. It is not useful to try to predict where the S&P 500 will be in 12 months or what the inflation rate in China will be at that time. But investors can try to find companies with products that demonstrate a low price elasticity of demand, or identify which industries are most reliant on low oil prices or require high capital expenditures to survive.
Most investors buy corporate equity or debt, either directly or through a fund. Microeconomics can help identify which corporations are most likely to use their resources efficiently and generate higher returns, and the tools of analysis are easy to understand.
What Is Macroeconomics in Plain English?
Macroeconomics is the analysis of the factors that move an economy, for better or worse. These are the factors that can cause supply and demand fluctuations in the economy. They include inflation, productivity, unemployment, and fiscal and monetary policy changes, among other factors. Macroeconomists analyze these factors in order to understand past or current economic cycles and to predict future ones.
Most economists identify themselves as macroeconomists or microeconomists.
What Is Microeconomics in Plain English?
Microeconomics is the study of the behavior of individuals and businesses in relation to economic pressures and opportunities. This analysis generally focuses on supply and demand in a single industry rather than an economy as a whole. Individuals and families make decisions on purchases based on their perceptions of their immediate or short-term financial welfare. Companies make similar decisions to expand or pull back, hire or lay off, step up production or look for places to cut back. Microeconomists study these behaviors and draw conclusions about the probable effect of those behaviors on a product or an industry.
How Can Microeconomics Be Useful in the Real World?
If you’re an individual investor, you may be using microeconomics already without realizing it.
Say you’re considering investing in a company that makes electric vehicles. Your research indicates that some consumers are willing to switch to electric vehicles in order to reduce their carbon footprints. The government is offering a big cashback offer that reduces the cost of these vehicles.
In your research, you’ll probably come across microanalysis findings that are based on the data behind the headlines.
Is there a sufficient infrastructure for recharging in place? What percentage of consumers is turned off by the sticker price? What do current electric car drivers think about their vehicles?
The Bottom Line
Macroeconomics may be more ambitious, but so far it has a much worse track record than microeconomics.
Microeconomics provides the tools that allow investors to analyze the fundamentals of stocks they are interested in. This provides a clearer picture of how an investment may move, in comparison to the noise generated by macroeconomics.