How to Embrace Bad Economic News

As we've seen in the past few days, good economic news doesn't necessarily mean good news for your returns. Of course, the next question is: Is bad economic news necessarily bad for my returns?

One of the most common errors investors make is to fail to understand that it's totally irrelevant to stock prices whether news is good or bad. This lack of understanding causes investors to react to the news: They get overenthusiastic when news is good, and they tend to panic when news is bad. To be a successful investor, you need to understand that all that matters is whether the news is better or worse than already expected.

One of the most basic principles of finance is that markets are forward looking, incorporating everything knowable into current prices. In other words, only surprises matter. And by definition, if something is a surprise, it can't be forecasted. The following is a great illustration, demonstrating that what matters isn't whether news is good or bad, but whether it's a surprise.

2010 was a miserable year for the commercial real estate industry, as mortgage defaults multiplied:

• In 2008, just 1 percent of commercial loans were delinquent.
• In 2009, the default rate jumped to 6 percent.
• In 2010, the rate jumped to 9 percent.

The contrast between the rising default rate and the rising value of commercial mortgages seems at first to be contradictory. However, there's a simple explanation - prices rose because default rates were bad, but not nearly as bad as the market was forecasting. The result was that market prices rose, reflecting the view that default losses won't be so great that damage will be done to the upper (more highly rated) tranches of the securitization ladder.

Nobel-prize winning economist William Sharpe provided this explanation of how markets really work: "In an efficient market, investors will incorporate any new information immediately and fully in security prices. New information is just that: new, meaning a surprise (anything that is not a surprise is predictable and should have been predicted before the fact). Because happy surprises are about as likely as unhappy ones, price changes in an efficient market are about as likely to be positive as negative." In other words, price changes are random and unpredictable.

As Joseph Mezrich noted: "Surprise is a persistently important factor in stock performance." This is a particularly noteworthy observation since Mezrich was the head of Morgan Stanley Dean Witter's Quantitative Strategies Group when he said it.

Not only are surprises a major determinant of stock performance, but because they're unpredictable and the market instantly incorporates the surprise into prices, you're best served by ignoring the news.

While the media and Wall Street need you to "tune in," the winning strategy is for you to "tune out" the noise. You should ignore the news because acting on it is highly likely to prove counterproductive. The proof of that is that studies have shown that investors have earned returns that are well below the returns of the very mutual funds in which they invest.

More on MoneyWatch:
Good Economic News Finally Arrives Why Good Economic News Isn't a Good Indicator for Stocks 6 Financial To-Dos by Year-End The End of Social Security's Interest-Free Loan How Costs Destroy Your Returns
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.