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The Things You Shouldn't Pay Attention To

There are 315 million people and 13 million businesses in America. The tax code is 73,000 pages long. Visa and MasterCard process 4,000 transactions per second. Forty-seven million Americans are on food stamps, the 400 richest Americans are worth $2 trillion, 254 million antidepressant prescriptions are written annually, and in the time it took me to write this paragraph 13 Americans filed for bankruptcy, 22 were married, and 21 died. 

The economy is so complex is it literally unfathomable. There are trillions of moving parts reacting to each other every second, often without making any sense or having any historical precedent. 

One of the most dangerous things you can do is pretend the economy, or the stock market, is simple and easy to understand. It causes you to see patterns that are really just random flukes, and wrongly assume that if one lever is pulled over here, something predictable will happen over there. This is one reason clueless, passive investors often outperform professional ones. Clueless investors aren't tempted by false-insight masquerading as brilliance. 

So take Munger's advice. If you want to do well, don't waste your time trying to be intelligent. Forget searching for patterns and correlations you think might explain the future. Instead, avoid being stupid by realizing what doesn't work, and what you shouldn't pay attention to. 

Take three examples. 

The economy and the stock market 
Do you want to know where the stock market is going next? I bet you do. And I bet you think that the stronger the economy is, the higher the market will go. 

But that isn't necessarily the case. What the economy does today tells you nothing about what stocks might do tomorrow.

This chart tells the story. 

Source: S&P Capital IQ, Federal Reserve, author's calculations

If you're a math geek, the correlation between current GDP growth and five-year subsequent stock returns is -0.06, or pretty much a random, drunk walk. Three-year forward-looking market returns aren't much different, at -0.09. For one-year returns, it's -0.21 -- still low. 

This goes so deeply against intuition. Most of us want to believe that market returns are driven by a strong economy and corporate profit growth. In the long-run, they are. But the two don't move in lock step. Markets are priced based on what people will think will happen in the future. Today's reality is yesterday's news. That's why stocks surged in 2009 even though the economy was a complete wreck. 

A lot of investors understand this. But read through explanations of why people want out of stocks, and you often get the same story: The economy's weak, unemployment's high, housing's a mess -- all of which may be true, but none of which may be relevant to investment returns. Save yourself some misery and stop paying attention to it. 

Economic data 
Want to know what the economy is doing right now? Pay no attention to initial economic reports. They will eventually be revised so many times that the only thing we know with confidence is that they are wrong.

Take the monthly jobs report, one of the most anticipated numbers of the month. Each report is revised seven times after its initial release; twice in the following two months, and once a year for five years after that. Deutsche Bank economist Joe LaVorgna tallied up all past revisions and found the average jobs report is revised up or down by 90,000 jobs, or nearly half the average initial number. 

If I told you the temperature outside is 70 degrees, give or take 30 degrees, you'd know it's a useless figure and has no connection to the actual weather. And you definitely wouldn't act on it, putting on a heavy jacket when it might be 100 degrees outside. But we treat economic numbers with the same margin of error as stone-cold fact -- and we often act on them. Watch the madness of people frantically trading stocks after the initial jobs report is released. They are basically reacting to a coin toss. Do yourself a favor and don't follow them.   

The economy and taxes 
Want to know where the economy is headed next? Don't pay much attention to politics, especially tax rates. 

This sounds crazy. Higher taxes take money out of the hands of productive workers. 

But look at the evidence, and what seems obvious in theory is elusive in practice. 

Take the top marginal tax rate and compare it to GDP growth. You get a big mess without much rhyme or reason: 

Source: Federal Reserve, Tax Policy Center. 

The best explanation here is that the advertised tax rate and the actual amount of taxes people pay are wildly different. Marginal tax rates only apply to a small segment of income, and deductions, write-offs, and loopholes can render them meaningless.

The United States has one of the highest corporate tax rates in the world, yet one of the lowest rates of corporate tax collection as a share of GDP. The top marginal income tax rate was 70% in 1981, and the average actual (effective) tax rate of top earners was 30.4%. By 2004 the top rate was cut in half, to 35%, but the average effective rate of top earners was barely changed, at 30.1%. 

There is a huge difference between tax rates and the rate of tax collection. As long as that's the case, claims that raising/lowering marginal rates will hurt/help economic growth have to include an asterisks that says, "All else equal, which it never is, and even then, maybe, maybe not." There's just not a lot of evidence either way. I know of no one who has correctly called the direction of the economy or the stock market based on changes in tax rates, but I know many who have erred disastrously in their attempts. Most tax debates have more to do with political philosophy than economics. Keep your distance if you're interested in making money. 

Most financial advice tries to make people better investors. I've come to the conclusion that it's more helpful to focus on how to become a less-bad investor. Realizing what we shouldn't do, and shouldn't pay attention to, is a good first step. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

Read/Post Comments (10) | Recommend This Article (72)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 31, 2013, at 4:05 PM, prginww wrote:

    As much as I'm a data and stats junkie and will remain so in the future, my wife has taught me that data and stats do not allow you to fully understand what is happening in the real world. For that you just need to go out in the world and see what's going on with people.

    For example: One argument that I've seen more times then I can count is that our economy is only created part time minimum wage jobs, so people can't afford to buy anything. But that jobs data is only from surveying the employer, not the employee.

    A guy we know started a business in the past year here in Sacramento. If he was surveyed for the jobs report he would tell them that he has created 10 minimum wage jobs that are less then 32 hour a week, and the BLS would report these as part time minimum wage's what that report won't tell you: The business he opened is a bar and grill and all his employees earn tips. Depending on the days they work and how good they are, they make 1200-2500 in tips a month and report almost none of it to the IRS. So despite all the talk about minimum wage being less then 1k a month their take home is closer to 3k. They all have cars under 5 years old, they have the latest technological gadgets buy clothes and go out to eat and drink several times a week.

    Sometimes you just have to go out in the world and ask yourself " Does the data I'm looking at correlate with what I'm seeing around me?"

  • Report this Comment On October 31, 2013, at 4:11 PM, prginww wrote:

    <<But that jobs data is only from surveying the employer, not the employee.>>

    I'd add: There are actually two employment surveys each month: The establishment survey, which surveys businesses, and the household survey, which surveys actual people. One of the main reasons we have a household survey is to track self-employed workers. You can get data on employment trends from either. (The unemployment rate comes from the household survey, and the monthly change in jobs numbers comes from the establishment survey.)

  • Report this Comment On October 31, 2013, at 4:59 PM, prginww wrote:

    As usual, the story is to focus on the few variables that you know with certainty and can control - i.e. time in market and costs.

  • Report this Comment On November 01, 2013, at 8:04 AM, prginww wrote:

    Broader studies of taxes and economic growth show that taxes do indeed lead to slower growth, especially corporate income taxes and highly progressive personal income taxes:

    Also, one of the reasons that corporate income tax revenue as a percentage of GDP is low in this country is merely a result of a different composition of business entities. Pass-through entities such as sole proprietorships, partnerships, and LLCs are very popular ways to structure businesses in the US. This tax revenue shows up on individual income tax returns instead of corporate returns.

  • Report this Comment On November 01, 2013, at 8:13 AM, prginww wrote:

    <<Also, one of the reasons that corporate income tax revenue as a percentage of GDP is low in this country is merely a result of a different composition of business entities.>>

    True in part, but not when comparing to to other nations. The US has one of the highest marginal income and corporate statutory tax rates, but still third from lowest in total taxes/GDP among OECD nations. The linked slideshow in that section goes into more detail.

    I'm not arguing that higher taxes don't slow growth. I'm pointing out that raising tax rates don't always lead to higher taxes. There's a reason the tax code is 73,000 pages long; there are more deductions and loopholes than can be imagined.

  • Report this Comment On November 01, 2013, at 10:34 AM, prginww wrote:

    Morgan: One of your better efforts. AND I might add, focused on important concepts rather than trivia.

    I could focus on trivia by arguing with you that your GDP chart merely shows that GDP does not correlate with the market, and GDP is a pitiful measure of "The Economy".. This would miss the broader truth that neither does the market correlate with good measures of the economy day to day. It might be MORE INTERESTING to plot market trends with an accurate measure of economic activity with several time delays if we had one, but wistfully wishing for some better measure of "economic activity" than GDP will not make it appear. So the only useful observation to be had is the ones you made in your article. An excellent accomplishment, not to mention excellent advice for your readers....

  • Report this Comment On November 01, 2013, at 12:10 PM, prginww wrote:

    <I><b> “Most tax debates have more to do with political philosophy than economics. Keep your distance if you're interested in making money...I've come to the conclusion that it's more helpful to focus on how to become a less-bad investor.” </b></I>

    I'll say it, but I'm probably going to get slammed by all the B.Comm's who write articles for Forbes saying studying anything that ends in "ology" is a waste of time, but if you sit back and observe, this is what Munger and others are saying: you want to be a better investor, study humanity to be more "consistently not stupid."

    Why study sociology, archaeology, anthropology, psychology, etc. to become a better investor Aside from the fact that they are scientific disciplines that study human behavior, they provide the tools to become more consistently not stupid. This is how to develop a "redundant system" in our mind to monitor what we do and what others do and cultivate the skills and abilities to change bad investing habits and knee-jerk reactions, develop self-restraint and self-control of our emotions, and refine our ability to distinguish between threats and non-threats, basically how to become a Navy Seal investor.

    No one is perfect, I'm not perfect, and I'm only in my third year of investing. I've been very impressed and also very disappointed with what goes on in the "investment world;" overall, less so with The Motley Fool approach. But I think Charlie Munger said it right in another quote of his:

    "I'm used to people with very high IQs knowing how to recognize reality, but there's a huge human tendency where it may be instructive to think that whatever you're doing to succeed is all right" - Charlie Munger

    So how do you get over the obstacle of thinking "whatever you're going to succeed is all right"? Buffett and Munger and others in the Investor Hall of Fame have a deep understanding of humanity, along with their highly disciplined financial minds, because they have cultivated a self-awareness that functions like a "redundant system" to monitor themselves and others.

    This might be all "ology" talk to many, but the average 7th grader can learn how to read financial reports in a Jr. High Accounting Class. If we can develop the ability to monitor what we are doing to succeed – our "redundant system" – then I think we'll be more "consistently not stupid." This is not something you are born with, but an attitude that you cultivate within yourself.

  • Report this Comment On November 01, 2013, at 4:33 PM, prginww wrote:

    You missed my point about the corporate income tax, Morgan.

    If a company is set up as an LLC (a pass-through) entity, then it will obviously not pay corporate income tax, but income tax *will* be paid on the income. Consider a country where *all* businesses decide to organize as LLCs in a country with extremely high effective corporate tax rates. Corporate tax revenue as a percentage of GDP would be zero despite the high effective corporate income tax rates.

    This is why you can't simply compare corporate income tax revenue as a percentage of GDP because the percentage of business income that comes from corporations varies widely from country to country.

  • Report this Comment On November 01, 2013, at 4:41 PM, prginww wrote:

    Thanks Mad, I got the point; I've written about the big shift in classifications before. That's where looking at total tax to GDP -- corporate, income, excise, etc. -- comes in. Even there, US has a high statutory and low effective compared with other OECD nations.

  • Report this Comment On November 04, 2013, at 3:33 PM, prginww wrote:

    Love it!

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