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What Does a Good Economy Really Mean for Your Portfolio?

It seems like common sense: If a country has a high economic growth rate, it would have a stock market with high returns. Kevin Grogan, my colleague at Buckingham Asset Management, takes a look at this little bit of conventional wisdom, and it doesn't seem to hold up when you look at the data.

It's important to remember that markets are highly efficient and that estimates of future growth are built into current prices. The academic literature on the topic illustrates this point:

There are three main reasons why we would expect economic growth and equity return to have a negative correlation.

First, the benefits of economic growth may not necessarily go to equity investors. The increased productivity could result in higher real wages, for example, instead of profits.

Second, as Siegel points out, most large companies are multinationals. The profitability of these companies depends on worldwide economic growth as opposed to the growth rate of a particular country.

Third, high expected GDP growth is built into current stock prices. If a country is expected to see serious growth, it's perceived to be less risky. Because you are compensated for risk, your expected return should be lower since your perceived level of risk is lower.

Think of it this way. Tiger Woods is expected to do well at this weekend's British Open. He was considered the safest play if you were picking one golfer to win the tournament. Because he is considered the safest play, you can't get good odds betting on Tiger Woods to win the British Open. The expected return from betting on the safest play is low. The same is true of investing in countries where the market expects high GDP growth.

Your time is better spent determining how much risk you should take rather than trying to find ways to achieve above market returns. The amount of risk in your portfolio is one of the most important determinants of the return of your portfolio.