Conventional wisdom can be defined as “ideas that are so ingrained in our belief system they go unchallenged.” Unfortunately, much of the “conventional wisdom” about investing is wrong. One example of erroneous conventional wisdom is that investors seeking higher returns should invest in countries that are forecasted to have high rates of economic growth, such as India and China.
It certainly seems intuitively logical that, if you could accurately forecast which countries would have high rates of economic growth, you would be able to exploit the knowledge and earn abnormal returns.
Unfortunately, relying on intuition often leads to incorrect conclusions. In this case, it fails to account for the fact that markets are highly efficient in building information about future prospects into their current prices, and investors fail to understand the difference between what is information and what is value-relevant information. The historical evidence on the correlation between country economic growth rates and stock returns demonstrates this point.
A Study Of Growth And Returns
The latest evidence comes from an August 2016 research paper from Dimensional Fund Advisors, “Economic Growth and Equity Returns.” Examining the data on 23 developed-country markets over the 40-year period from 1975 through 2014, and for 19 emerging markets over the 20-year period from 1995 through 2014, DFA found no significant relationship between short-term economic growth rates and stock returns.
Countries were classified each year as either high or low growth depending on whether their GDP growth was above or below that year’s median, defined separately for developed and emerging markets. Researchers then looked at the stock market returns of high- and low-growth countries over the following year.
The return for each group is the average stock market return of all the countries in that group weighted by countries’ market capitalization. They found not only no statistically significant relationship between economic growth and future stock returns, but in developed markets as well as emerging markets, the lower-growth economies produced higher returns.
In the developed markets group, the high-growth countries returned 12.0% in the following year, while the low-growth countries returned 13.1%, although they did so with higher volatility (21.2% versus 19.1%). In the emerging markets group, high-growth countries provided higher returns (12.9% versus 12.6%) while exhibiting lower volatility (34.9% versus 38.9%).