Guten Tag Readers!
We are back again with another interesting topic !
So far we have discussed investment principles, investment avenues, and in general how to understand investment from common sense.
Now we would like to take a step further and dive deeper into the fundamental drivers of investments - The economy.
We had previously covered the economy from a divergence perspective along with a brief on economic cycles, today we explore that area a bit further.
Lets uncover how understanding economic fundamentals can help you make better investment decisions.....
1. Demand & Supply: The first brick in the house
The concept of supply and demand is the most basic principle of economics as well as investment.
In its basic form it states that as the product prices increase, the sellers supply more quantity because they receive higher incentives. The other side of the coin is that as the prices decrease, the consumers demand more of that product. For a transaction to take place we need an equilibrium point, when the supplier is ready to sell at a price that the consumer is ready to buy at. That’s the simplest rule for any transaction for any product type.
This equation is the main engine of economic activity and is crucial while making investment decisions.
In investment instruments, especially in stock markets, this principle gets applied at every step, every transaction.
In the context of shares, when
Buyer's demand increases, share prices increase
Buyer's demand decreases, share prices fall
Therefore, the point of equilibrium i.e. my transaction point ,keeps changing.
Every single transaction is the result of the application of the above principle popularly called as the law of supply & demand.
Drivers of Supply & Demand What causes a change in supply & demand? The supply and demand of any investment instrument (like any product) is driven by various factors.
For the ease of our readers, we segregate these factors into two parts based on the level of financial awareness. Refer illustrations.
2.The Economic Drivers: Cementing the bricks
As discussed above, the law of supply & demand necessitates that equilibrium be reached to achieve a transaction. In the world of investments, this price achievement for the transaction is based on a pricing mechanism.
What is a pricing mechanism?
When you buy a product, you determine its perceived value in terms of your own notions and emotions : how much happiness you might derive out of it, how much utility it provides, or maybe simply because someone else is buying it!
What if we tell you that the same mechanism applies to investment, yes!
The perceived value of products can be related to the fair value of an investment based on analysis or expected future earnings in the case of a business. The utility can be related to how much potential that investment has for you to generate returns. The last parameter is FOMO, which is prevalent in the investment world exactly as it is in our daily world. (Fear of missing out)
The economic environment and its impact on investments is the primary consideration for realizing an effective pricing mechanism. And the economy moves in cycles, right? The different parts of the economy perform well in different business cycles at different points of time. Sometimes the demand for houses are more (Real estate), while sometimes the demand for automobiles is more, and sometimes the demand for consumer products is surplus!
Consider a very simple example:
When the economy is performing well as a whole, people have jobs, they tend to build a new house and spend more. New houses will require new mortgage loans, boosting the financial system. Those houses will boost the furniture, construction and other related industries. When these industries perform well, labor and people involved with them tend to spend more, and the cycle continues to drive the growth of different types of businesses one after the other. The culmination of these different business cycles leads to economic growth.
For reference read one of our previous articles covering Economic Cycle Mapping
3. Picking your Investments
Once you have uncovered the fundamental understanding of the economy, you start cementing the bricks in the house, and move to finer details of building your house.
As an investor, you need to look ahead and anticipate the different business cycles that are about to move up based on the business and consumer behavior around you. The whole idea is that different investment instruments will serve you well in different economic cycles.
Now, we understand that explaining the whole economy in a single newsletter will be treacherous for us and saturating for you to consume so much content. Hence, we leave you with the simplest content out there to understand the Economic Engine. It's an amazing short video!
Until next Thursday, Happy Investing!!