22 September 2008
Share market investors have weathered extreme events every decade but it's important to understand the big picture, remain diversified and keep looking for sound investment options, experts say.
At the sign of crisis, there are plenty of Cassandras preaching doom and gloom and exhorting investors to seek safe havens.
But the reality is we do not know what the future holds and cannot predict it with any degree of certainty.
Well-known US futurist Harry S Dent is another pessimist, releasing a new book this December called The Great Crash Ahead - 10 steps to the Next Great Depression.
Let's hope he's not right.
But even if he is, it doesn't mean you can't capitalise on volatility, provided you have prepared as best you can.
James Holt, Equities specialist at BlackRock Investments, says that investors are often best off when they think in a contrarian way, rather than be influenced by all the negativity surrounding the present global economy.
"It is easy to see that investor sentiment could get worse with all the bad news being reported but history tells us that markets tend to recover before the recession is fully over, even though that's when investor sentiment is usually at its worst," says Holt.
A fine example of this is economist John Maynard Keynes' story, who made a fortune in the stock market during the depression.
Investing without a crystal ball
As investors we are not prepared for Black Swans - a metaphor for the unexpected event.
If we were, we would have prepared better for the 1987 crash, 1998 Asian crises, and the recent sub-prime fiasco.
And we spend a lot of time rationalising after the event in order to come to terms with the event itself.
However you prepare, you cannot plan for the unknown, argues author Nassim Nicholas Taleb in his book: The Black Swan - The Impact of the Highly Improbable.
US Defence Secretary Donald Rumsfeld, in a memorable press conference, distinguished the 'known unknowns' and 'unknown unknowns'.
Taleb, who is not a great fan of Republican politicians, told The Guardian that Rumsfield himself did not understand it.
He defines Black Swans as events such as the fall of Long-Term Capital Management in 1998 and September 11, 2001.
These are not only rare events but predictable, says Taleb, in retrospect.
"We never see them coming but have no trouble concocting post-hoc explanations for why they should have been obvious," says Taleb.
Taleb a former trader told The New York Times: "I cannot find a single, convincing argument that tells me that astrologers won't do better than economists".
But James Holt Equities specialist at BlackRock believes it's also important to remain diversified to protect yourself against so-called "Black Swan events", such as September 11.
"Being an investor in an insurance company or property exposed significantly to such an event, would obviously have been disastrous if that's all you owned, but less so if it was part of a diversified portfolio," says Holt.
Mr. Taleb points to the reliance on some investors on financial models, the quantitative wizardry that can churn reams of data in an instant.
These were the same models, he points out, that in the lead up to the sub-prime mortgage meltdown, assumed home prices would never decline on a nationwide basis.
Taleb is right on this point, which is indicative of 'irrational exuberance' and the speculative bubble in US housing, which is holding back economic recovery in the US.
But it is the one event recently where some economic commentators did warn of a housing bubble.
Nevertheless, experts are now watching the US housing inventory for signs of recovery before there is a consensus the bottom of the crisis has been reached.
Colonial First State's Hans Kunnen says investor sentiments is driven by America, and that the bottom of the market is still hard to work out because the US is still working through problems.
"Investor sentiment is gloomy in the US, with US housing prices still dropping; it affects bank profits, which in turn affects the share market. There is an estimated trillion dollars worth of losses and we are only up to $500 billion".
"There is more bad news to come from the US", he adds.
Hans Kunnen says the gloomy mood of investors can be attributed to the fact that they move like a herd.
"They're susceptible to the big picture and psychology plays a big part and it's expected that when the market goes down, investors get gloomier," he says.
Half empty is also half full
Kunnen says the doom and gloom comes from the media, but the Australian economy is still a good cause for optimism.
James Holt says when the market has bottomed out, and the share market is at its cheapest, it's still difficult to convince investors to return.
"Warren Buffet tells the tale that in the Buffet household there is hallelujah when hamburgers fall in price because you get more for your money.
"The same applies for stocks; when they fall in price you get more for your money - that's often the best time to invest."
"But for some strange reason", Holt adds, "investors only want them when prices are high, and not when they're a bargain!"
Holt says investors have found cash to be a safe haven once again, as they tend to every ten years or so.
But cash hasn't been the best performer in a calendar year since 1994.
"Having served it's purpose, people shouldn't risk keeping all of their money there too long.
"In the long run, the risk of being out of the market is even greater than the risk of being in the market; investors over-exposed to cash are likely left behind when markets recover.
"Any fall in rates in the next year will reduce the allure of cash and also help other markets; bonds will get a kick-a-long. It's also a positive for share market," he adds.
