Investment philosophy, process and outcomes

In some regards investing is like dieting. It only works if you have a good philosophy, good plan, and you stick to it over the long term. So what is our investment philosophy at the Suburban Economic Investor?

Investment philosophy

We are strategic, top-down investors. This means we invest according to macro-economic trends. We select relatively few investment asset classes, we abore excessive diversification and the notion of buy and hold for the long term. We don't trade; our ideal is 1-2 major investment decisions per year if that. Our heroes' are sage investors like Jim Rogers and Marc Faber who correctly picked commodities and China as boom investments (and the US as a poor one), and we smart enough manage those investments to protect downside. Our economist heroes' include Nouriel Roubini (RGE) and Paul Kasriel (NTRS).

So how does it work. Four simple steps based on foundation knowledge of financial and economic concepts.

1. Monitor and understand the global economic situation
2. Select asset classes likely to benefit (high positive economic value) over the medium term
3. Select individual investments within these asset classes
4. Manage entry, risk and exit to investments

For example. In 1999 our sage heroes' Rogers and Faber identified commodities as a group where at two decade generation lows. They also understood the central banks were printing excess money and that real rates would become negative which was bullish for commodities, and bearish for the USD. In 2003 they recognised China's entry to the WTO would spark a huge boom in that country. In 2006 these sage's went short financials recognising the imminent US housing bust. In 2007 they went long agriculture stocks. We don't pretend to be able to match this performance, but we do intend to 1) understand the fundamentals, 2) follow the global economy, 3) follow the sages by selecting good asset classes, 4) manage risk in our investments carefully.

Investment process versus outcomes

Investing is a probabilistic field in which both the likelihood and payoff for a decision in important (more on this later). In these fields the long-term investment philosophy and process are more important than short-term outcomes. We can control our investment philosophy, but we can't control short-term outcomes. Consider that in the following matrix:

We can't control the market, but we are aiming for an investment process which will deliver either deserved success or unlucky outcomes. We don't want to confuse blind luck with investing genius on our behalf. This 2 dimension by 2 dimension (2 x 2) matrix introduces both game theory and expected value concepts which are highly important to financial and life decision making. At its simplest we consider the performance what we can control (our investment process), with that which we can't control (market outcome). A useful concept for making all sorts of decisions with imperfect information.

Primary, secondary and tertiary economies

In this post we look at the GDP (gross domestic product) of the largest 20 nations. We first divide the these nations into primary (commodities), secondary (manufacturing/services) and tertiary (IT, advanced manufacturing, consumer) nations. We then group these nations into a simple trading model between primary, secondary and tertiary nations. Without further ado, here are the top 20 nations GDP based on 2007 data. Note the list reflects my simple categorisation based on the nations primary role. All nations are ultimately primary, secondary and tertiary producers at different levels.

Primary Producing Nations (predominantly):

• Canada USD$1.43 trillion
• Brazil USD$1.31 trillion
• Russia USD$1.29 trillion
• Australia USD$0.91 trillion
• Mexico USD$0.89 trillion
• Turkey USD$0.66 trillion
• Indonesia USD$0.43 trillion
• Saudi Arabia USD$0.38 trillion
• Iran USD$0.29 trillion
• South Africa USD$0.28 trillion
• Argentina USD$0.26 trillion
• Venezuela USD$0.24 trillion
• TOTAL: USD$8.38 trillion

Secondary Producing Nations (predominantly):

• China USD$3.25 trillion
• India USD$1.10 trillion
• South Korea USD$0.96 trillion
• Taiwan USD$0.38 trillion
• Thailand USD$0.25 trillion
• TOTAL USD$5.94 trillion

Tertiary Producing Nations (predominantly):

• European Union USD$16.83 trillion
• United States USD$13.84 trillion
• Japan USD$4.38 trillion
• TOTAL USD$35.057

The following graphic illustrates the relative size of these three trading blocks.

What to draw from this? Well, in my humble opinion we can divide all spending into either consumer or government spending. Consumer spending includes housing, energy, food, and discretionary retail spending; plus commercial spending related to meeting consumer markets. For example Boeing building 787 aircraft is ultimately consumer spending as the end user of that product are consumers. Government spending on the other hand is either consumer spending (healthcare, education) or nation building (infrastructure, defence).

My point here is that consumer spending is a huge part of tertiary nations' GDP. Any hiccup to western consumer spending brought about be rising food, energy or credit costs, combined with reduced employment prospects based on recessionary fears is a big issue. Can the primary and secondary nations de-couple from tertiary nations and become power world economy? These countries were very coupled on the way up, will they couple as the west heads south?

Based on this simple analysis it would seem they will stay coupled on the way down. A western recession (US, EU, Japan) is a global recession. Keep a close eye on what happens in the US and EU economies as an indicator for your local economy.

For the record, the GDP of the top 35 nations is shown below along with their cumulative contribution to global GDP. Note again how important western 'credit ladden' nations are to this picture.