Diversification and Investor Distrust

Investors don’t trust the equities markets. That’s the theme of a number of articles out over the past couple of days.  The Wall Street Journal’s portrait of panic on the day of the Flash Crash details how massive institutional traders’ behavior lead to the the amazing downward spiral and how only a market rumor — of a “fat” fingered mis-typed trade — slowed it. Plenty of people in the piece are worried we could see a repeat.

In the Financial Times, Gillian Tett connects market distrust to ongoing investor behavior. Trading volume is way down in a number of markets and retail investors have pulled more than $40 billion out of US equity mutual funds since May.  Investors, she says, are “on strike.”

But where is that money going to? And what price will investors pay in the long run for pulling out of equities? According to Tett,  government and investment grade bond funds seem to be the beneficiaries, with most recently, some uptick for junk bond funds too.

In his latest, The Investor’s Manifesto, William J. Bernstein, cautions: “The best time to buy stocks is often when the economic clouds are the blackest, and the worst times to buy are when the sky is the bluest.”

But whatever the forecast, Bernstein always recommends the shelter of diversification. In the book he argues at length neither the case for equities nor the case for bonds, but rather the case for both. And for those with the means, the case for REITs and value stocks and a specific exposure to global markets, too. Diversification isn’t just about upping returns,  Berstein explains, it’s about decreasing risk. Without it,  investors will have a hard time winning what Bernstein calls “Pascal’s Wager as it applies to investing,” the challenge to:

Maximize your chances of a comfortable retirement and minimize your changes of living out your final years in poverty.

At naked capitalism Yves Smith has some helpful historical perspective. He also notes that rather than throw up their hands, or wait for regulators to try to come up with some fix, large institutions themselves might take some helpful steps right now. Out of self-interest if nothing else :

..We are a long way from the revulsion towards financial markets of the later 1970s and early 1980s. Some restraint on behalf of dealers could help restore faith in markets. But like the fable of the scorpion and the frog, modern trading firms seem unable to change their nature, even when their conduct is self destructive.

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