Stimulus or Broken Window? Beware Diversification Fallacies

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I am naturally skeptical of anyone that is too confident about their investing strategy. There are no guarantees in the market or the economy so the very fast push for the stimulus (government investment) currently moving through congress is naturally something that is raising warning flags. Whether you agree with the need for a stimulus plan or not don’t ignore the uncertainty and risk.

[VIDEO] Stimulus or Broken Window?

Regardless of political feelings, investors can and should be dealing with the risk of a stimulus very proactively. By accepting and dealing with uncertainty you can avoid the investor trap of “talking your position.” Too often traders and politicians in defending their chosen plan of action refuse to acknowledge the potential risks and refuse to consider alternatives. Talking your position like this can lead to mistakes and a very exposed portfolio.

The risk of any stimulus is that it could be nothing more than a broken window. The broken window fallacy can best be described with a short story about a small village with its own economy. In this village a small boy throws a rock through the baker’s window and breaks it. Is the boy a hero or a villain?

The argument for heroism is that the boys actions have caused the baker to spend money to buy a new window. That money is now available to be spent by the glazier in supplies and equipment. The supplies and equipment manufacturers can use the money to pay their employees who in turn may buy bread from the baker. In effect the boy has unlocked the value that was frozen in the window and the village’s economy is now benefiting.

A stimulus that spends money on bailing out broken companies, public works projects and pork is like the boy. The boy is taking money from the U.S. consumer and then injecting it into the economy to stimulate growth. It is widely believed that this is justifiable because it is hypothesized that each dollar injected in the economy will “multiply” and ultimately provide a bigger benefit that the raw value of the injection itself.

The premise for the boy as a hero (or the need for a stimulus) depends on the assumption that the “baker” or U.S. consumer would not have used that money to spend and invest anyway. It assumes that the baker or consumer would have only hoarded that money and kept it idle.

An equally valid argument can be made that in fact the “boy” or government has merely reduced the value of the economy by one window because the baker or consumer would have spent or invested the money rather than hoarding it. By taking action like this, the boy has actually made the economy worse.

The point of this article was not to prove that one argument is valid while the other is worthless. In fact, no one knows which one is correct or why it will or won’t work. That is the real take-away from this discussion; that uncertainty can work against you. If the stimulus doesn’t work in the near term and growth does not come back to equities long stock traders will be worse than they are today.

By sowing the seeds of doubt, I hope to motivate investors and traders to start thinking about diversification across asset classes. Educate yourself about how assets like currencies, fixed income or commodities behave during recessions. Anyone can learn to implement strategies that decreases account volatility and protect against risk and there are plenty of free resources to do so, including our very own little Learning Markets site.



Image courtesy Jason Hargrove.