Secrets Of Success: Shares may not be worth the risk

Well, you cannot say that stock markets have failed to live up to their long-term reputation in the past few days. Investors have once again been reacquainted with the idea that shares earn higher returns for a reason: they are riskier and more volatile than other types of mainstream investment asset.

A quick scan through the performance tables shows how sudden and marked the move in the markets has been since the squall first blew up last week.

Out of 670-odd stocks in the FTSE All-Share index, as of Thursday morning, 95 per cent of them had fallen over the previous seven days, 60 per cent were down by more than 5 per cent, and 18 per cent by more than 10 per cent.

Overall, stock markets have had their sharpest correction in more than three years - a long overdue decline after a period in which volatility has become something of a forgotten factor in the market.

As always these days, it is a global market phenomenon we are witnessing, with Wall Street down for five out of six consecutive sessions, something that has not happened for a good while.

Nevertheless, one needs to keep these things in perspective. If you look at the long-term chart of implied volatility, derived from the options market, despite the spike of the past few days, we are still a long way short of the levels of volatility that were common until about three years ago.

The tough question everyone wants answeredis whether the dramatic movements in prices of the past few days are one of those "blips" that hit the markets from time to time, or a portent of something more enduring.

To answer that, one has to start by reiterating the conventional advice for private investors, which is never to be panicked into action purely by a sudden market movement. As markets are 100 per cent unpredictable in the short term, acting on any sudden movement (up or down) is illogical and unwise.

Studies of long-term market history show that most of the long-term returns from equities are concentrated into a relatively few trading days. Unless you are highly confident that you know where we are in the cycle, it follows that you face poor odds if you make large or precipitous changes in your portfolio.

Put this another way, if you are confident that your original asset allocation was correct, then there is no reason to be bounced out of it just because the stock market has moved quite suddenly. That volatility should, in theory, have been factored into your original thinking (although one wonders how often this excellent advice is followed in practice by most investors).

Owning a broadly diversified portfolio and making gradual adjustments to your market exposure is the only sensible way to operate, in preference to making big bets on a single decision.

While, in retrospect, markets seem to go up or down in a straight line, in practice they are invariably interrupted by interim movements in the opposite direction to the trend. Even if you have decided to make a gradual change in your market exposure, the trick is to wait for opportunities to buy (or sell) into these counter-trend movements.

There are still some things one can say with confidence about financial markets. One is that the relative attractions of different asset classes can and do change over time, as do investors' attitudes to risk. There are also patterns that do repeat over time with a fair degree of predictability.

From this longer-term perspective, it won't come as a surprise to many readers that a significant setback in the stock market - and in riskier assets as a class - looks overdue to me after the strong and impressive performance of the past three years. It is no accident that smaller companies, emerging markets and commodities have been the worst sufferers in the recent downturn.

In the case of metals and other industrial commodities, they have become dangerously dominated in recent months by speculative trading, even though the longer-term supply and demand picture for those industries suggests that these sectors are still strategically attractive.

Many of the professionals whose opinions I have come to respect have been urging caution for some time. This week I shared a platform with Anthony Bolton, Fidelity's star fund manager, in London.

While he would be the first to admit that he doesn't waste much time on market direction, and claims no special talent at it, he reiterated his gut feeling that the current bull market was near its peak.

He has backed this up with the unusual step (for him) of taking out a put option on the UK stock market to provide some protection of his funds against the eventuality of a significant market correction.

True, a week earlier I spent an hour with Ken Fisher, the American money manager. He presented a forceful case for thinking that the downside risk in stock markets over the next two years is not that great. He expects shares to remain the best-performing asset class, while bond yields fall and the dollar strengthens (remember that markets in the past have always gone up in the third year of a presidential term - which 2007 will be).

At some point, however, one has to back one's own judgement, and it seems fairly clear to me that we are entering a period when risk aversion will increase and riskier assets will produce relatively disappointing performance.

If that is right, then investors will increasingly head for the relative safety of large cap stocks (and if volatility remains at its higher levels, expect the smarter hedge funds to post some excellent numbers). I certainly see no reason to reverse my own strategy, which has been to lighten my equity market exposure in steps over the past few months.

Whether or not we are seeing a major turning point in the markets, to parallel those of March 2000 and March 2003, is too early to say. But, whereas most of the time the markets can be safely left to their own devices, I shall be on "turning point watch" for a while yet.

The technical behaviour of most markets in recent days suggests to me that a turning point of some kind might be imminent, though false signals are also part of any professional market-watcher's life.

jd@independent-investor.com