17 MARCH 2007, Page 40

The risk of cataclysm has not gone away

Jonathan Davis says investors should remember the lessons of the Edwardian era — and beware of complacency Even before the world’s stock markets had their latest wobble two weeks ago, an interesting debate was gaining currency at some lunch tables in the City. As always, the debate in the moneyed classes is primarily about risk. It’s only those without money who spend their time worrying about beating the market and making the most out of any investment opportunity they can find. For those who have, discretion has always been the better part of value.

The debate stems from the fact that risk, in its conventional financial sense, appears to have gone walkabout. The way most investment assets are priced these days, there appears to be barely a risk in the sky. Just about everything has been going up in price, and may well be going higher. Investors seem to have adopted the Blairite principle that, hey, things can only get better.

But in the real world, risks rarely disappear. They merely disappear from view. Instead, what can change, and change quickly, are perceptions. However rosy the prospect, any unexpected event, even an unsubstantiated rumour, has the capacity to change those perceptions in an instant, even if only for a few days.

Forget the flapping wings of a butterfly and its unexpected consequences elsewhere in the world. In today’s round-the-clock markets, it doesn’t take much to send a ripple of anxiety skimming round the time zones. Within hours of the recent stockmarket plunge in Shanghai (as Elliot Wilson describes on page 42), London and Wall Street followed suit. Yet the Shanghai market is so small that it barely registers on the global stage; the idea that events there could threaten investors round the world is implausible at best.

There is a more likely explanation for these synchronised global falls: share prices have been on such a strong run in the last six months that they simply ran out of momentum. There have been only three occasions since 1980 when the London stock market, for example, has put together as many consecutive positive weeks as the 21 it managed between October and the end of February when the wobble occurred. The longer that runs of this kind persist, the sharper the setback when it finally occurs. Thereafter, more often than not, it’s back to business as usual.

But is there perhaps something more profound going on beneath the surface? Some market watchers certainly want to believe there could be. Niall Ferguson, the conservative historian, chronicler of both the Rothschild dynasty and the world’s bond markets, asks this rhetorical question: why have financial markets been so complacent when the real world appears to be such a dangerous place? ‘When you read the news section, you’d think the world is going to hell in a handcart,’ he is quoted as saying in the latest issue of the US stock-market weekly Barron’s, normally an unlikely place to find an Oxford and Harvard historian. But ‘if you read the business section, you’d put the paper down thinking that life is as good as it could possibly get. All assets are up. All markets are liquid. All systems are go. The two sections don’t seem to be describing the same world.’ What worries Ferguson is the notion that the Middle East is heading for some sort of cataclysm that might do for today’s gung-ho investors what the first world war did to the rentiers of Edwardian England.

Then, as now, he points out, the pre-war period was characterised by steady economic growth, low inflation, growing world trade, benign capital markets and a widespread belief that the sun would never set on the Empire (British then, American now). Yet at the same time, while many investors foresaw the risk of war, few did anything to prepare themselves for that risk. Bond investors in particular were complacency itself. Yet within a few years, wartime inflation was to knock great chunks out of the value of their holdings.

Such gloomy historical parallels don’t cut much ice with many modern market participants. The world, they point out, was in reality a less secure place then than it is now. In global economic terms, Iraq is a sideshow. More than two billion people in China and India are joining the capitalist system for the first time, ushering in what should be a new era of rapid global growth.

With their instant communications, soph isticated derivative instruments and policing by a new generation of central bankers who have learnt how to tame inflation, modern financial markets, the optimists argue, are so broad and deep that financial risk is far more effectively dispersed around the globe than it was in days gone by. Worry, in other words, is for wimps.

That view might be more comforting were it not for some disturbing findings of behavioural finance, the modern academic discipline that studies how people behave with their money. These show that investors tend to give too much weight to recent experience and discount that of earlier periods, just as Niall Ferguson argues they are doing now. Investors are also prone to exaggerate small immediate risks and underplay, or dismiss altogether, those that are further away or cannot easily be measured. This is the same mental condition that prompts Californians to take out huge amounts of insurance against obscure diseases, or being hit by an asteroid, while continuing to live on top of faultlines that make another earthquake a high probability sometime soon.

In other words, even if investors knew that some sort of financial cataclysm was coming, but not when, they might still not choose to price in that risk. And such considerations take no account of the blunter distortions that may be caused by the incentives which make Wall Street and the City of London such a rewarding place to work. It is other people’s money on the whole that keeps professional investors at work; so if there’s a $5 million bonus on its way, who cares, frankly, whether risk is correctly priced or not?

A more prudent reaction to last month’s sudden stock-market fall might be to say that that is no immediate reason to think the good times in most financial markets are over. Equally, however, there is no reason not to think that some malign turn of events, not necessarily on a cataclysmic scale, but serious nonetheless, is likely to happen one day soon. In which eventuality, the prices of many financial assets will fall and those who have prepared for the unforeseen will live to fight another day.