I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.

Now this is not the sort of statement that most investors expect to hear from their stockbroker or investment manager. In current market conditions clients are likely to be unnerved by such a statement and think that it may time to look elsewhere for more expert investment advice.

If you did look elsewhere, you would be sacking the most consistently successful modern investor, Warren Buffett. His investment company, Berkshire Hathaway, has outperformed the S & P 500 index by an average of 11% per annum over the last fifty years. This outstanding feat has been achieved during a period of incredibly diverse economic conditions.

The Easter break provided an ideal opportunity to reflect on the events of the past week. The week started with the US Federal Reserve stepping in to organise the sale of what was previously a titan of Wall Street, Bear Stearns. Bear shares had fallen by approximately 90% within a week as the company became the latest high-profile banking victim of the credit crunch. Investor confidence, already very low, plummeted and triggered considerable volatility in capital markets; the FTSE 100 fell by 3.8% on Monday alone.

Many investors are questioning what action they should take now?

The answer very much depends upon your investment beliefs. If your investment strategy is based upon continually trying to outguess the market over short periods of time, then you will either need to be an investment genius, employ the services of a modern day alchemist or have incredible luck. Warren Buffett comes as close as anyone to being an investment genius but if he cannot forecast and then take advantage of short-term market movements, what chance do you, your financial adviser or stockbroker realistically have?

The reason why experts like Buffett do not get drawn into trying to forecast market movements and adopt short term trading strategies, is that they understand that stock prices and thus market prices do not follow clearly discernible patterns. Random walk theory states that future price changes are independent of previous price changes, and therefore future prices cannot be forecast with any degree of certainty. Most amateur investors and many professionals refuse to accept the implications of random walk theory. These investors will continue to make investment decisions based upon hunches or at the other extreme, follow strategies based upon highly sophisticated computer analytical models which aim to find order and predictability in historical stockmarket movements. Understanding the lessons of random walk theory ensures you acknowledge the importance of not letting short-term market conditions dissuade you from adopting and remaining faithful to a sound long-term investment policy.

But this presupposes that a client has selected a sound investment policy, which is suited for their particular circumstances and risk tolerance, with diversification geographically and across different asset classes. Investors who are overexposed to individual securities or esoteric investments have much to be concerned about. It is unfortunate that the dangers inherent in poorly constructed portfolios are often only exposed in falling markets.

Conclusion

Charles Ellis, in Winning the Loser’s Game compares the phenomenon of investors’ decision making being driven by short-term events to mistaking the difference between the long-term climate and the daily weather.

“In choosing a climate in which to build a home, we would not be deflected by last week’s weather. Similarly, in choosing a long-term investment program, we don’t want to be deflected by temporary market conditions”.

Understanding the long term ‘climate’ of capital markets will not only help you make better investment decisions when you establish your portfolio, but also help you remain focused and unemotional during the inevitable down periods. Patient investors will be able see past the random short-term ‘weather’ conditions which will inevitably be replaced by more predictable patterns over long time periods when capital markets reward investors for accepting risk.

At Collins Ward, we structure investment portfolios across multiple asset classes to minimise the potential for capital losses, and also tilt portfolios to benefit from the higher risk premiums available from some market sectors. These premiums are not available every year, but consistently reward investors who hold firm to the investment policy over the long-term, in the same way as short-term weather patterns revert to the long term ‘climate’ average.

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