Sunday, 16 September 2007

Using Freedom to Predict Share Market Returns

Most people invest in the country they live in. For someone in a small economy like Australia this can be worrying because of fears of lack of diversification. If you are going to invest outside Australia then where should you invest? One educated guess that comes to my mind is that countries that are economically free are better. If I can find a country that is economically free but has experienced low growth then I can buy shares in that country and expect lots of growth.

A measure of freedom is the Heritage Foundation's Index of Economic Freedom, and in Chapter 4 of the 2007 Report they go on and go about how the index of economic freedom correlates to per capita GDP. So far so good. This means I can use the index of economic freedom to predict per capita GDP. However, just because the people are rich it doesn't mean there will be any share market growth. Unfortunately for me, Raymond da Silva Rosa from the University of Western Australia claims that the two are unrelated: "As it happens, the theory and evidence on the association between changes in share market prices and the economy do not support such an inference. There are at least three reasons why there is not a strong association between share market prices and economic growth: competition, market efficiency or rather inefficiency, and alternative sources of capital."

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