Friday, November 19, 2010

Outside the Flags: Weather vs Climate

Jim Parker, Vice President, DFA Australia Limited

Notice how TV stations put finance next to the weather report on the evening news? In each, talking heads point at charts and intone about stuff that in most cases will be quickly forgotten. In the meantime, the long-term story gets lost.

It's an old tradition, but a certain segment of the investing population tends to feel that they aren't sufficiently informed about the financial world unless they have checked daily or hourly on how the Dow, FTSE, Nikkei or All Ordinaries have moved in the intervening period.

It's a pretty harmless activity in most cases. It at least provides a bland conversation starter in fleeting social encounters, just as keeping up to date with tomorrow's weather forecasts can fill an awkward silence.

But our very human focus on the day-to-day and the short term can often encourage us to make bad decisions that affect our long-term interests.

Here's an example: On October 30, 2009, The Australian Financial Review led its markets section with the headline 'Shares Slide on Fears for US Housing'. The Australian equity market had suffered its largest one-day fall in more than four months after unexpected news of a slowdown in the US housing market.

Now, an investor who closely scrutinizes the daily market reports may have taken fright at this story and informed their financial advisor that they were not convinced the global economic recovery had traction and they wanted out.

But the very next day, the story had changed completely. The same newspaper led with the headline 'US Growth Spurt Puts Market Back on Track'. In this case, the US Commerce Department had reported stronger-than-expected economic growth figures which had helped ignite a marked reversal in sentiment.

Our plugged-in investor might have changed his mind at this news and told his advisor to ignore what he had said the day before.

But wait! There's more. Another day passed and this time The Australian Financial Review splashed with 'More Bad News on the Way'. A renewed fall on Wall Street on the back of news of a decline in consumer spending had local markets primed for another bad day.

And on it goes. From day to day to day, market sentiment shifts in reaction to news—news about the economy, news about companies, news about governments and politics and the wider world. Prices rise and prices fall in response to this news, which by definition is unpredictable.

Think of it like the weather. One day it's sunny. The next day it rains. It's unseasonably warm one day and uncharacteristically cool the next.
*ASX-500 Accumulation Index, Jan 1980-Oct 2010; Source: Returns Program
What can you do about it? Well, in the case of unpredictable weather, you can ensure you're equipped for all conditions—an umbrella, a raincoat and some sunscreen in your bag just in case.

Likewise, in the case of investment, you can stay diversified. That means you don't have all your money in one type of asset—like just property for instance or just shares or everything in cash. You need a mix in your portfolio so it can withstand a range of outcomes and keep you in line to meet your goals.

The nightly news is interesting, undoubtedly. But it's like the difference between the weather and the climate. One changes constantly; the other more gradually and imperceptibly. With investment, it's the climate you need to think about.

*ASX-500 Accumulation Index, Jan 1980-Oct 2010; Source: Returns Program*ASX-500 Accumulation Index, Jan 1980-Oct 2010; Source: Returns Program