Jonathan Davis: A brave new world for investors

Many of the major long-term economic risks we face are now, in effect, foreseeable and insurable

Not many pundits had a good stock market bubble: amid all the cheerleaders for stocks who willingly suspended their disbelief, only a few dared to say publicly that retribution was inevitable. Professor Robert Shiller of Yale University has no reason to be shy about his track record. His last book, Irrational Exuberance, an academic study of speculative market bubbles, hit the bookshops in March 2000, the month in which the stock market burst. Like all good books, it reads even better with the benefit of hindsight.

This is how Professor Shiller begins his final chapter: "The high recent valuations in the stock market have come about for no good reasons. The market level does not, as so many imagine, represent the consensus judgement of experts who have carefully weighed the long-term evidence. The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom."

It was, he argues, "a serious mistake for public figures to acquiesce in the stock market valuations we have seen recently, to remain silent about the implications of such high valuations and to leave all commentary to the market analysts who specialise in the nearly impossible task of forecasting the market over the short term and who share interests with investment banks or brokerage firms".

His conclusion is that individuals, foundations and those soon to retire should be prepared for the possibility of share prices falling by as much as 50 per cent – back to their mid-Nineties level. This is what has happened. Such a decline, he says, would be equal in terms of value to the destruction of all farms in the US and would have a disproportionate impact on the less well-off.

Three years on from this powerful and timely warning, Professor Shiller is returning to the bookshops with a new study that holds out, amidst the thunderous clamour of savaged financial expectations, the tantalising prospect of a saner, fairer and more secure world for employees and savers. His argument is that the combination of new technologies and new financial instruments could now – if we chose to use them – remove many of the problems of inequality, anxiety and folly that haunt the economic world.

In The New Financial Order, Professor Shiller makes the point that most of us adopt an indefensibly lopsided view of risk. We give an undue amount of weight to risks that are immediate and relatively trivial, but do little about the much bigger risks that stand to make a far bigger difference to our welfare and livelihoods over a lifetime. So while people are happy to spend money on expensive warranties for TVs and other durable goods, we rarely take steps to protect ourselves against disability or unemployment.

One reason for this, he suggests, is that our perceptions of risk are driven more by emotion than by dispassionate assessment of the risks we face and their probabilities. If the newspapers are full of one specific risk (Hong Kong respiratory disease being a good case in point), it distorts our perceptions of what really matters.

The stock market bubble is an example of the syndrome in reverse: investors who rush to chase such fads are driven by an emotional need to avoid missing out on a money-making opportunity when all logic tells them it cannot last. In general, Professor Shiller says, we assign too much importance to the stock market as an indicator of the health of our economic wellbeing; in practice, corporate profits, which ultimately drive share prices, provide only a snapshot of a much broader picture.

A second, more valid, reason for our misreading the nature of the real risks we face lies in the fact that the bigger risks that impact on our lives – the risks of war, inflation, and economic decline in the profession we have chosen – are hard to measure and assess. Anyone who opted to become a nuclear scientist in the Sixties had little way of knowing his chosen profession was doomed, and had little chance to take out effective insurance against such a failure even had he or she been blessed with a keener knowledge of the risks.

The key argument that Professor Shiller makes is that many of the major long-term economic risks we all face are now, in effect, foreseeable and (thanks to new technology) insurable. Inflation-linked bonds, introduced in the Eighties, are one example of an insurance policy not available to previous generations. They allow us to protect our savings against the risk of renewed inflation more certainly – and with less volatility – than the traditional havens of equities and property.

Pensions are a more difficult example. The risk of disappointment and/or economic hardship for tomorrow's generation of retirees is not in doubt. Demographic change makes it inevitable that the proportion of retired people is going to rise over the next three decades, while the number in work declines. Pensions funded through the stock market are almost certain to fall short of providing the next generation of pensioners with the kind of retirement incomes their parents and grandparents enjoy. The risk here is one of an arbitrary transfer of wealth from one generation to the next.

The good news, on Professor Shiller's analysis, is that it is now possible to conceive and construct trade-able indices that will allow insurers to offer protection against such things as industrial decline and demographically-induced pension shortfalls. If we all knew such insurance was available, we could afford more risks with our choice of career, to the benefit of the economy. Creativity is the lifeblood of capitalist economies. Emotional worries about the risk of unemployment are one of the biggest threats to continued innovation

In Professor Shiller's utopia, newspapers would publish every-day indices that tracked the progress of the stock market, and the health and prospects of different professions, different generations' retirement prospects and different economies' growth rates. In the last case, investors could buy an index fund whose performance was linked to the growth rate of the world economy, the ultimate diversification for anyone worried their home-country economy might falter and decline.

All these factors stand to make a big difference to the quality of our lives from cradle to grave. The data and technology to make a market in such things exists. All that is lacking, Professor Shiller says, is the will to make them a commercial reality. That day is still some way off, but we could start by taking a more hard-nosed assessment of what will really make a difference to our lives. The replacement cost of a video recorder is not one.

davisbiz@aol.com