Secrets Of Success: Chill out; equities are always volatile

So far, so good. It seems that the markets have started to restabilise quite nicely after the excitements of the week before last.

As usual, those who have suffered most from the gyrations are those with leveraged or trading positions. Anyone with a geared long position has had to scramble to protect themselves (although there will be others on the other side of the trades, albeit a much smaller number, who will be licking their lips with satisfaction at the turn of events).

The latest episode serves to remind us of some important lessons of equity investment. One is that the risk of equities as a class does not change from year to year. They have always been volatile; and if you are uncomfortable with seeing the value of your portfolio fall by 3.5 per cent in a day, which will happen from time to time, you should not be owning equities in the first place.

Second, watching the market every day (as anyone now can do, thanks to technology and the power of the internet) is a mixed blessing. By accentuating the apparent volatility of the market, having the value of your investments marked to market every minute of the day tends to feed all the irrational and emotional impulses that make human beings less than perfect investors.

It will be interesting to see, in this context, whether real estate investment trusts (Reits) change the attitude of investors towards the attractions of commercial property. As they are quoted companies, with prices listed every day, the price of Reits appears to fluctuate more dramatically than conventional commercial property funds, even though the assets they hold may be more or less identical. Perceived risk, in other words, can differ from intrinsic risk purely as a function of whether something is a traded security or not.

The news media, it has to be said, being naturally attuned to reporting on daily rather than longer-term events, does not help much in this regard. You may have noticed a third phenomenon about market wobbles, which is that suddenly the news is full of negative items, whereas in bullish phases the same events will be downplayed or ignored.

The reality is that the fundamental forces to which the financial markets must ultimately respond move very slowly in comparison to the markets themselves. Worries about the sub-prime mortgage lending market, to take one topical example, are hardly new. They have been exercising many professional market commentators for some time. The problems at HSBC, which chose to become one of the big players in this market through acquisition, did not suddenly appear overnight.

The difference is that, in the light of a sudden market move, such concerns move from being one of a million potential market-moving factors to the first immediate explanation. On this point, I cannot do better than quote Professor Jeremy Siegel, the celebrated market egghead from Wharton University of Pennsylvania and author of Stocks for the Long Run and other such books.

"Individuals," Professor Siegel tells us, "have a deep psychological need to find fundamental explanations for why the market is doing what it is doing. It is very discomforting for many to learn that most movements in the market are random and do not have any identifiable cause or reason. Most investors find comfort when someone explains to them 'why', even though on further thought they often know that the explanation given is unlikely to be the true cause of market moves."

So, for example, if you are seriously worried about the sub-prime mortgage lending market in the United States, it's worth pointing out that it accounts for a truly tiny percentage of the $10 trillion mortgage lending market in that country. While what is happening in that market may be a symptom of deteriorating credit conditions, it is hardly going to bring financial markets crashing to their knees.

While stock markets are inherently volatile, they do go through patches when all the movement appears to be one way. Such phases of positive momentum, when prices rise apparently without pause week after week, always draw in new buyers and bring their own dangers. The longer such momentum markets continue, the more likely they are to be interrupted by a sudden break of the kind we have just witnessed.

The final point, of course, is that markets cannot escape the pull of valuations. The more they rise, the more expensive (other things being equal) they become. At some point, they have to run out of road and revert to more normal levels. Unless capitalism has been suspended altogether, there is a finite limit to how high profit margins and corporate earnings can rise.

One appealing argument for the strength of real estate and most financial markets in the past few years is that the spread of globalisation, coupled with the effective control of inflation, has produced a one-off change in the ability of the world financial system to spread the risk of owning investment assets, to the benefit of all of us. That might justify investors paying a lower premium for risk than in the past. But how much more secure are we as a result? Somewhere along the way, amid the day-to-day market turbulence, we will in due course find out the answer.

* Bill Mott, the veteran income-fund manager, is returning to full-time money management at a new boutique, Psigma. Meanwhile, his former employer, Credit Suisse Asset Management, seems to be imploding, having lost virtually all its top fund managers in the course of the last year (the most recent defection coming this week with the departure of its multi- manager team to Thames River Capital).

Dr Mott is a class act, so unless his sabbatical has dulled his appetite, consider adding his new fund, when it opens, to your list of possibles for next year.

jd@independent-investor.com