The Chain Game

How Identifying Economic Links can Prove Rewarding for Your Portfolio

By Anthony Rhodes

As intelligent readers of How To Invest, I’m sure that you are all familiar with the phenomenon known as The Butterfly Effect: an understanding that seemingly insignificant details can have serious and dramatic influence on complex systems. This comprehension reflects itself more broadly in the sayings “An apple a day keeps the doctor away”, or “An ounce of prevention beats a pound of cure”, but the premise behind these catchphrases are all identical, in that they describe an undeniable connection between causes and effects, be it in matters of science, or health, and believe it or not, in matters of economics, as well. 

Interpreting the economic consequences of this dynamic, and converting it into worthwhile investment opportunities, is one of the characteristics which distinguishes great portfolio managers, from good ones. Just about anyone can deduce that an accident at a prominent oil refinery will have a negative impact on short-term oil prices, but recognizing that an unexpectedly violent volcanic eruption in the Arctic, can cause soft drink prices to fall half a world away, is one of the observations reserved only for the conscientious; who are able to follow these unseen links to their profound and rewarding economic conclusions. So this week, we’ll discuss the importance of honing your skills in this particular area, with the ultimate goal being, to get you to understand that noticing the connections which align situation to location to industry to product, is far more than a mere intellectual exercise, but that it holds significant implications for your portfolio, whether you choose to acknowledge them or not. 

Simplifying Complexity

It’s nearly impossible for the novice to completely understand the interconnectivity of all the ingredients, goods, products and services which amalgamate into the system we call economics, let alone the vast network and influence of outside forces, which can place this system in a state of flux. So, without attempting to guide you in this direction, perhaps it’d be best to focus on the areas of our economy, in which you find interest, which is more likely where you’d also invest. If you enjoy athletics, it’s not a far reach to assume that you might also own an athletic apparel stock. If retracing the supply line of the products of such a company, you’ll discover a listing of specific materials which are essential to their creation. Once these items are identified, begin to think of all of the conditions which could have an adverse effect on their production; which will, in turn, potentially impact company earnings. This knowledge will provide you with a first mover advantage when or if such incidents occur, and provides a rudimentary introduction to the basis of this weeks’ topic.

Universal Links

This exercise is easy to perform when dealing with companies within similar sectors, but as the complexities of groupings increases, so too must the ability to identify the connections between them. Just as chess Grand masters can anticipate an opponents’ reactions multiple moves ahead, successful practitioners of this craft can identify the underlying fundamental links which connect multiple sectors together, and more importantly, how individual actions can affect them all. For example, a hurricane in the pacific, whose activities disrupt sugar cane production, will obviously affect sugar producing companies. But what might not be known, is the multitudes of other sub-sectors, whose products indirectly require glucose as a source material, will also be affected. Using this method of correlation will provide you with informative insights into the potential movements of various companies. And although I don’t expect you to become an expert on this discipline after reading this post, understanding the basic processes by which it works, will most certainly place you on the right path.

The statement “No man is an island” emphasizes the important, and necessary dependency which we all have towards one another. It implies, for good or bad, the undeniable fact that we are all interconnected, and that no single person, regardless of talent or resource, is free from this entanglement. But such a declaration can also be made of corporations, as they also require one another to maintain their survival. And that by applying capitalistic principals to these perceived associations, allows individuals to profit from their interactions, long before others begin to realize that they even exist.      

(Anthony Rhodes is a Registered Investment Advisor and owner of wealth management firm The Planning Perspective )