Wednesday, April 07, 2010

It Won't Last

Jim Parker, Vice President, DFA Australia Limited

Long-time watchers of financial markets know that investors are always worrying about one thing or another. What's not often apparent is how quickly those worries are built into prices and how rapidly the narrative changes.

The recent fretting points for investors have included, among other things, default risk in southern Europe, the threat of China's economy over-heating, the dependency of risk assets on government stimulus and the implications of proposed regulatory reforms in the international banking industry.

A rule of thumb with a lot of these hot-button financial and economic issues is that by the time you read about them in newspapers and magazines, the markets have moved onto worrying about something else.

Take Greece for example. A search on Bloomberg of the words "Greece and default" yielded nearly 300 news stories in the month of March. The subject of these articles extended from fears of outright default to, by the end of the month, news of a strengthening in the euro as Greek fears receded.

A search of the word "stimulus" on Bloomberg yielded more than 600 news articles in March, extending from Brazil's attempt to lure investors with infrastructure spending to news that Japan's retail sales were growing at their fastest pace in 13 years, thanks partly to government stimulus.

In this age of rapid global information flows, aided by web-based distribution, news is incorporated into prices almost instantly. A geopolitical development like a bomb blast in a Moscow subway, or economic news such as an agreement on a bailout for Greece or company-specific news like a Chinese firm buying Volvo from Ford….all of this tends to find its way into prices before the average person has heard that it has even occurred.

So it shouldn't be a surprise that many investors err by tinkering with their own portfolios based on information that is already reflected into securities pricing. This is like chasing a moving target or trying to catch a falling sword.
No sooner have you pondered, for instance, the implications of Y2K or the SARS virus for your portfolio than the market has decided that this issue is a flash in the pan and has gone onto worrying about something new.

A better approach is to accept that markets are extremely efficient at incorporating fresh information into prices and that trying to second guess how they might react to a particular event is a hazardous game.

By the way, one senior Australian advisor has developed a successful technique for dealing with queries from his clients about the implications for their portfolios of whatever issue happens to be dominating the financial media headlines at that time and whatever the state of markets.

"To be completely honest, I don't know what the implications are," he says. "But I can tell you this: It won't last. Now let's talk about your news."

This seems to be a healthy approach to responding to news that's dominating the markets. It's interesting, it's topical, it's forever changing and, for the most part, there is very little you can do about it.