The Science of Investing

Is it possible a trade deficit is not a harbinger of economic doom? Rather, it’s symptomatic of a healthy economy? That’s pretty unfathomable.

In the graph, you can see those clever Germans and Japanese have run trade surpluses while the U.S. and U.K. have run big and growing trade deficits. But which economy would you rather have? Both the U.S. and U.K. have had robust GDP growth and above-average annualized market returns since 1990, while Germany and Japan have had sluggish growth and below-average returns. Their trade surpluses haven’t helped them. In fact, the data show the reverse of the myth might be true — that deficits are healthy and surpluses undesirable. How could that be?

Japanese and German Trade Balance As Percent Of Gdp (view chart)

Both Germany and Japan have governmentally imposed economic throttles aimed at artificially creating trade surpluses, under the belief that surpluses help their economies. Not so — this mercantilist experiment hasn’t worked in their favor. Increased governmental meddling inhibits the wild will of capitalism and dampens growth. The U.S. and U.K., having deeper faith in capitalism, have avoided such silliness and been well-rewarded. Fathom that: Trade deficits, in developed nations, are a great good thing.

We’re not done yet. Always, when confronted with any investing dilemma, ask what your brain is doing to muck you up? In my book, I detail some common cognitive biases causing investors to have a distorted view the world — myopic loss aversion, confirmation bias, order preference and more. A cognitive bias is when your brain distorts reality to fit some comfortable notion. It’s not your fault. Studies in behavioral finance show this is more a result of how the human brain evolved than any personal failing.

A major way your brain misleads you on trade deficits is investors tend to provinciality. Cavemen thought about their tribe and didn’t care much about their neighbors, unless under attack. Today, Americans think America matters, and we pay less heed to economic heathens outside our gate. But why? By examining the U.K., we see our silly deficit prejudice is unwarranted. And the Brits are practically American! We don’t share a common language, but we share a similar disdain for the French.

By adopting global thinking, you realize trade deficits don’t matter. Globally, there is no trade deficit — it all balances. You don’t fret if Montana has a trade deficit with New York, so why break into hives when the U.S. has a trade deficit with China?

Some may argue most Americans don’t invest globally. They fixate on the S&P 500. Even if you reject global investing, against my recommendation, you must still think globally. Developed economies are far more correlated than you realize. If we have a trade deficit, and that’s bad, and other nations have a surplus, and that’s good, shouldn’t our stock returns be all over the map?

U.S. vs. Foreign Markets (view chart)

In any given year, U.S. and foreign markets tend to move in the same direction, as shown in the graph. It’s very rare for the U.S. market to be down big when the foreign market is positive. If our big deficit mattered, we should see much more differentiation in market returns.

If you can get global thinking in your bones, many other misplaced investor concerns fall away. You needn’t worry about U.S. inflation, since it’s the global supply of money that matters. You know U.S. GDP doesn’t matter much; you must look at global GDP growth since America is only 38 percent of global GDP. If you do that, you’ll definitely know what others don’t, since most investors’ vision blurs at the shoreline.

Even with global goggles, some folks still fret. Deficits just feel wrong — the word shares a Latin root with “deficient,” and that must be bad. How else are our brains betraying us here? You hear frequently that Americans’ profligacy causes the trade deficit (among other problems). Shame on me, and you too! This is evidenced in our personal saving rate which garnered much press by recently turning negative. Egads! We’re unsaving!

This is the illusion of validity, another cognitive bias, at work. Isn’t it common sense that Americans are all crass profligates? And there’s data to back it up! The saving rate proves it. Our brains love an “expert” or data confirming what we already believe. And while disproving one myth, you find another to tackle with the three questions.

My book fully details why the personal saving rate doesn’t matter (in fact, a negative rate is probably a good sign), but governmentally produced data should always be viewed with extreme cynicism.

Using the questions, you discover in 2005 that the U.S. government deducted nearly $1 trillion from the saving accounting. What was this massive line item? The amount of rent Uncle Sam thinks homeowners ought to pay themselves for living in the homes they own and occupy. Insanity! I own a home, and I don’t pay rent to myself. (Maybe you do because you’re crazy.)

In my view, I’m actually saving myself rent money. Sure, some folks pay a mortgage (which government accountants consider an expense, while dinging you a second time for fake rent), but they’re paying interest on an appreciating asset, not paying rent.

Even crazier, did you know Bill Gates, the world’s richest man, never saved anything? The government says he didn’t! (The government says I never saved either, yet Forbes was crazy enough to put me on their list of richest Americans.) He started Microsoft which became incredibly valuable, but he never saved. I started my firm. Maybe you started a firm, too.

Today Americans primarily save through capital gains in one form or another. Americans increase their wealth in diverse ways, but the government doesn’t know how to calculate that. Unrealized capital gains aren’t included in “savings,” while journalists scold us for being profligate. And we believe our naughtiness contributes to a trade deficit, which upon deeper analysis isn’t something to fret about either.

The good news in all this is most folks will continue to worry about a trade deficit wreaking havoc. But, because what they expect to happen probably won’t, and you know that, you can bet against them and win. Put that to use in your portfolio this year, because trade deficit bears are still pounding their drums.

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Kenneth L. Fisher is founder and CEO of Fisher Investments, an independent, global money management firm. He has been writing in Forbes since 1984. His new book, The Only Three Questions That Count, is just out from John Wiley & Sons.