Predicting Investment Returns

The key to predicting, or attempting to predict, how an investment will perform lies in understanding the movements of the economy. Economists analyze certain trends in the economy called economic indicators to look for hints about trends in the economy. Understanding where the economy might be going helps an investor make decisions on whether or not to make changes in their investment portfolio.

Economic indicators can be leading, lagging, or coincident. Lagging indicators shift after the economy changes. Although they do not typically tell us where the economy is headed, they indicate how the economy changes over time and can help identify long-term trends. Lagging indicators include things such as changes in the GDP, changes in unemployment rates, the consumer price index which helps track inflation, currency strength, and balance of trade. Coincident indicators tell us where we are at currently. Coincident indicators include employment, real earnings, average weekly hours worked in manufacturing, and the unemployment rate.

It is, however, the leading economic indicators that give investors the most information about the direction of the economy. The leading economic indicators can give investors a sense of where the economy is headed in the future, paving the way for an investment strategy that will fit future market conditions. The leading indicators are designed to predict changes in the economy, but they are not always accurate so reports should be considered in total, as each has its own problems. Review the slideshow below to learn more about leading economic indicators.

Any lesson on predicting future returns on investments must begin with this qualifying statement: Any returns on investment, whether stock, bonds, or mutual funds, are essentially unpredictable in the short run. There are two ways to benefit from the ups and downs of the economy while investing for the long term. The first, which we learned about in an earlier lesson, is diversification. The other is dollar-cost averaging.

Dollar-Cost Averaging

Dollar-cost averaging is a method used to reduce risk by steadily purchasing investments at specific intervals for specific amounts, rather than by purchasing investments sporadically in larger sums. By consistently purchasing small amounts of investment over a period of time, you gain the advantage of automatically buying more investments when prices are low. This fulfills the investment mantra of buy low and sell high. Consider the chart below.

In this scenario, had you invested the entire $1800 in the first month, you would have only been able to afford 120 shares ($1800/$15). Through dollar cost averaging you are able to buy 41% more shares.

An additional benefit of dollar cost averaging is that it is relatively simple. Setting up a dollar cost averaging plan takes only three steps:

Decide how much you will invest each period. Make sure it is something you can afford to do for the long-run or it will not be effective.
Select an investment you would want to hold for the long run. An index fund would be particularly suited for this.
Invest your money at regular intervals.

Self-Assessment

Take a moment to review what you have learned with the flashcards below.

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