How Much Economics Do I Need to Know to Manage Investments?

Economists believe that you need to know economics to understand how the world works. More bluntly, they believe that  lawyers, MBAs, and many in the investment world just don't understand how the world works if they don't have a solid grounding in economics. In fact, the self-taught late economist Jude Wanniski wrote a book humbly titled The Way the World Works in 1998.

So what do economists understand that most people don't? What should you get out of a good intro to economics course? What is the take-away for the financial literacy crowd?

A good place to start is with the book, Economics In One Lesson by Henry Hazlitt. Hazlitt does an excellent job of explaining many of the principles first expounded by Bastiat. The one that has gained the most notoriety has been the "Broken Window Fallacy." This fallacy points out the importance of considering what isn't seen. In a nutshell, a thug breaks a window and a group of people reaches the conclusion that it isn't such a bad thing because it creates work for the glazier in repairing the window. What isn't seen is the suit of clothes the shop owner would have bought with the money spent on repairing the window.

Hazlitt provides numerous examples of where the broken window fallacy arises in every day economics and its consequences. In the process, he brings out the importance of understanding long-run and short-run consequences of policy actions.

Economics also teaches important points for investors to know about prices. For example, in a competitive market, where the product can be produced (example: housing), rising prices put in motion forces that will bring prices down. Understanding this fundamental principle, taught in every intro to micro course, could have saved the nation considerable resource waste over the last several years.

This is not intuitive to many investors. Let me cast it in terms of another example that looks at the flip side. If a tree falls and punctures our roof, we might be inclined to wring our hands and moan that the house will be flooded in the next rain storm. This, of course, isn't likely for the simple reason that we will look into getting it fixed. Similarly when the economy goes into a crash-and-burn state, our intuition tells us to bail. But again, this is exactly the wrong thing to do. Behind the scenes, actions take place to turn markets around. This is what was happening in early 2009. Powerful fiscal and monetary policy programs were  implemented.

A second point to understand about prices is the concept of asymmetric information, whereby typically a seller knows more than the buyer about the product being sold. The important work in this field was done by Akerlof in 1970 in a piece titled "The Market for Lemons: Quality Uncertainty and the Market Mechanism."  In this article, Akerlof examined the used car market and why buyers are more likely to get a "lemon."  Sellers will tend to hold on to well-maintained, etc. used cars and sell cars with problems into the used car market. The average used car then will be of poorer quality than is true of the entire population. This fundamental principle explains why buyers took toxic structured product debt and considerably exacerbated the 2008 financial crisis.

Incentives is another area that economics focuses on. For example, economists readily understand that there is typically more information indicated by an insider buy than by an insider sell. Insiders sell for many reasons -  to buy a second home, to pay little Joey's tuition - because options have granted more shares. They buy typically for one reason:  they like the company stock prospects.

These are all, of course, micro type considerations. On the macro level, a solid intro to economics course will provide the foundation for understanding the ongoing debate about macro economic policies as well as international considerations such as why the dollar is imploding. For those seeking a very solid intro to macro text, I would recommend a used edition of Mankiw's Principles of Economics paperback.