Dominic Wallington: The paradox of volatile shares

We are surrounded by paradox. Whether it be Russell's Paradox, which arises within naïve set theory by considering the set of all sets that are not members of themselves (to be a member you have to be a non-member), or the knowledge that the worse our TV programming gets the more it becomes a part of our lives (how else can Big Brother be explained?), they are all too prevalent. One of the most interesting paradoxes in the financial world currently is that while western economies have become more stable, financial markets have become more volatile. If the everyday investor were to look at stock markets today, he or she would naturally conclude that the economy is lurching from crisis to crisis and the threat to business on a daily basis has increased appreciably over the last decade.

Let's look at some history. There have been many column inches on the speculative boom and bust of the railways in the 1890s, while the similar computer-based bubble of the 1960s has been ignored. The "go-go years", as they are known, are fascinating in the context of the current downturn because the similarities are striking. In 1965, US Federal Reserve chairman William McChesney Martin Jnr warned that talk of having entered a "new economic era ... in which business fluctuations are a thing of the past" was highly reminiscent of the late 1920s. He voiced his concerns for the economy but also said that structural changes meantime meant that any downturn would be more muted than in the 1920s.

If we look at the downturns that followed the 1960s (1973-74, 1980-82, 1990-91 and 2001) then a clear trend to reduced economic volatility can be seen. Alan Greenspan commented on this recently without explaining it, but Martin, in the 1960s, mentioned several differences between his era and 1929, including the better distribution of national income and more stability of wholesale prices. Today, further changes are clear: the growing stability of household income, a far higher percentage of the workforce in less cyclical service jobs, the joint utilisation of fiscal and monetary policy to regulate the business cycle, and a reduced correlation between the output of big industries as economies have become more complex and diversified.

If this is so, why haven't equities become far less volatile? The paradox is that they haven't and the answer must be that the type of risk has changed. If most risk formerly came from the background economic environment and this has reduced without any apparent change in overall risk, then there must be a greater degree of risk from within the market itself.

The structure of the market has changed fundamentally and new technology means that everyone gets the same information instantly. So if everyone decides to buy or sell a share at the same moment the resultant price reaction will be amplified, leading to increased volatility. Transaction costs have fallen, discouraging the former tendency to sit it out and wait for better times to re-appear; now, selling is a much easier prospect.

All of these factors would be manageable if there hadn't been greater uncertainty over the value of assets in the late 1990s. If it is difficult to work out how influential a technological change will be, it becomes difficult to value the companies that will benefit or suffer as a consequence of it. Thankfully, a lot of this valuation uncertainty has now gone, and therefore the situation will in some respects settle, but stock markets will remain more volatile than the wider economy. The answer is to be brave and act in a contrarian manner.

Dominic Wallington is a UK institutional equity fund manager at Invesco Asset Management