Hamish McRae: Patience may be a virtue, but sometimes it pays to speculate

Economic view
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Patience is a virtue in so many aspects of human endeavour, so how do you harness it to create more stable and better-functioning financial markets?

That is the theme of a speech* to be made this Thursday in Beijing by Andy Haldane, the executive director at the Bank of England in charge of financial stability. The arguments he makes deserve a wider airing because the West's financial system has developed, quite recently, in ways that are not just unstable but as we now know, do not do the job they are supposed to do – getting savings into appropriate investments – well.

The nub of his argument is that finance can develop in two ways. In one, patience becomes self-reinforcing, so that financial liberalisation encourages better investment decisions and unleashes economic growth. In the other, impatience also becomes self-reinforcing, encouraging over-trading and under-investment. China, he argues, seems to be following the former course and the task is how to prevent it overshooting on to the impatient path. For countries that have already liberalised their financial systems, "the choice is how to promote patience while harnessing impatience".

How indeed. Dr Haldane discusses the patience "gene" and its counterpart, and in particular the evolution of patience and deferred gratification. Thus we know that people who save more and spend less are happier than those that don't. We know that some people have deeply destructive habits but we also know that people can be nudged into self-improving behaviour. He cites a study that showed that if people are given a small financial inducement to go to a gym that radically changes their fitness behaviour.

So how do you encourage patience in finance? There have been self-improving financial cycles in history, from the Medici banks in 13th-century Italy to joint-stock companies in the 19th century and to the explosion of capital market finance towards the end of the last century. China, he argues, is on a self-improving cycle.

To head down such a path you need liquidity and information. But too much of these encourages excess: excess trading, excess credit and excess volatility. Most of us would agree that we have seen too much of that. But the debate about this leads into a series of puzzles, which one could sum up in the question: "Why are markets so inefficient?" Prices swing far away from the levels justified by fundamental economic conditions and as a result markets make mistakes in allocation of resources. (Sure, all other methods of allocating capital seem to be worse, witness the huge errors made by governments when they try to do it.)

But there is a problem, a big one. You might imagine that, in terms of investment, patience should win out. Investors that follow the common-sense fundamental approach of buying when shares are low relative to economic fundamentals and selling them when they are high should do better than the speculator who buys when shares are rising and sells when they are falling. That isn't the case. Imagine two investors, each investing $1 in US equities in 1880. The fundamentalist, who bought when shares were low and sold when they were high would have found his or her stake falling to 11 cents by 2009. The speculator, the one bought when they were rising and vice versa, would have more than $50,000. In Britain, the divergence is not so dramatic, but the speculator investor would still do better than the fundamentalist.

You see the problem. There seems to be a built-in incentive to chase share prices up when they are rising and chase them down when they are falling. This is an obvious recipe for volatility.

It gets worse, or at least it may be getting worse. There has been a surge in high-frequency trading – racing in and out of stocks in micro-seconds. The right-hand graph shows how the average length of time investors hold their shares has fallen, with the biggest decline from the 1960s through to 1986 when London adopted the reforms known as "Big Bang". But in the past year or two, the scene has been transformed by the rising speed of execution. You could not carry out trades in fractions of seconds 10 years ago because you couldn't settle the deals. In the US, high-speed firms may now account for 70 per cent of equity trades, while in Europe it is apparently 30 to 40 per cent. These seem to have accounted for the crash that took place in many US share prices on 6 May this year. As Dr Haldane points out, we still don't know why this happened but we do know that: "The impatient world was found, under stress, to be an uncertain and fragile one."

This is not just happening in finance. The tenure of chief executives and football managers has plunged too – the average "life" of an English Football League manager is less than 18 months.

So what's to be done? I take some comfort from the fact that despite this increased impatience, share markets have returned to some sort of sanity in underlying values. The left-hand graph shows the FT All-Share index over 80 years up to 2009. It also shows the "fair" value of UK firms, as measured on the assumption of what has happened to dividends and a constant relationship between prices and dividends over that period. Prices overshot massively in the 1990s but by 2004, the last trough of share prices prior to the collapse of March 2009, they were back to an OK value. I suppose that they won't be too far away from fair value now.

But from the perspective of the policy makers, saying that share values are reasonable does not help. Policy makers have to head off the next catastrophe and I think Dr Haldane would accept that the banking crisis was the result of a collective failure of monetary, fiscal and regulatory policy by the national authorities, including the central banks.

He draws four main conclusions. One is that as countries, such as China, liberalise their financial systems, they need to do so cautiously. A second is that policy needs to lean on volatility, by encouraging longer-term holdings of securities, say. Third, we need ways to nudge people into longer-term contracts, for jobs, savings and so on. And fourth, governments must think longer-term and have institutional arrangements that push in that direction. Giving the task of maintaining price stability to central banks is one such example.

And the message for investors? It is true that over the past 120 years a US investor would have been better to follow a speculative strategy than a value one. But Dr Haldane notes that if you invested $1 in 1967 in an investment company whose motto is "our favourite holding period is forever" it would by 2009 be worth $2,650. If you invested it in the markets generally it would be worth $75. So maybe a "buy and hold" strategy is not such a bad one for these uncertain times. You can work out which investment company it is for yourselves, but I will give you a hint. Its founder hails from Omaha.

*'Patience and Finance', Andrew Haldane, Oxford China Business Forum, Beijing, 9 September

Three ways to stay sane in the mad, mad world of spending cuts

We are now heading towards punch-up territory on public spending, seeing how the 25 per cent (or whatever) spending cuts will be allocated between departments ahead of the spending review to be revealed on 20 October. There is always a huge amount of jostling and jousting during these periods, as stories are leaked to try to improve the relative positions of departments, and lobby groups go into "squeal before you're hurt" mode. This is nothing new, but we have tended to forget what it is like because of the long high-spending years.

But one thing is new. There is the external discipline – or at least semi-external – of the Office for Budgetary Responsibility. It looks at macro, not micro, but the big numbers have to more or less add up. By then, the OBR will have a new head, quite possibly Robert Chote, currently head of the independent Institute for Fiscal Studies and, many years earlier, a writer on this newspaper. And, by the way, it is worth setting on record why the OBR's previous head, Sir Alan Budd, left after three months. That was his contract and there was never any question of extending it. So why did the Government not make that clear all the while? Ask the Chancellor, but I gather it suited him not to make clear quite what the deal was.

So, how should we react to this string of stuff? I suggest three rules to keep sane. First, ignore obviously partisan attacks on whatever is supposed to be in the plans. It is the job of pressure groups to apply pressure. Second, beware the extent to which the departments will seek to offload pressure on to bought-in services from the private sector. One of the really worrying aspects of any public spending cuts is the extent to which the core protects itself. And third, remember that this plan is only a first shot. Spending reviews set out frameworks, and wise departments will be able to fine-tune their plans in the years ahead.

So will the new spending targets be met in the latter years? Of course not. They will gradually be eased. Remember that, too.