Soap Box: Discipline is key to weathering the economic storm

Published on Friday 31 October 2008 19:52

BUBBLES conjure up childhood images of blowing soapy bubbles out of a plastic hoop, or relaxing in a luxurious bath.

A financial bubble, however, is a catastrophe: a disaster that affects billions of people threatening the roof over their heads, their retirement and their children's future.

And so, in what might be the aftermath of the simultaneous "pop" of the credit, property and stock markets, we may begin to ask why this was ever allowed to happen.

Unfortunately, no matter how hard we try to learn the lessons of the recent financial turmoil and no matter how we regulate the markets, it is almost inevitable that this will all happen again.

Throughout history, financial markets have a simple calling card; whether surrounding Tulips in 17th century Amsterdam, the 18th century South Sea bubble, radio stocks in the 1920s, dotcoms in the 1990s, or residential property in the past few years, they are generally accompanied by the ominous phrase, "it's different this time".

This phrase is often the currency of every trader, market maker, journalist and commentator desperately trying to convince us all that the market is special this time.

Just think of all the fancy explanations given for the unsustainable rise of property prices: immigration; demographics; the rise of divorce; low interest rates.

So too were we told in the late 1990s that a paradigm shift had occurred in the economy to support the ridiculous valuation of tech stocks. ("Paradigm shift" is of course a fancy way of saying "it's different this time").

The trouble is that each generation still learns the lesson of financial bubbles the hard way. Markets have very little institutional memory and traders who drive the market are rarely in their high-pressure positions for long.

They trade financial assets, bid up prices and invent new and exciting ways to morph financial risk into something more palatable, much in the same way as mechanically-recovered meat is reformed into a tasty but ultimately unhealthy sausage.

The stock market and shareholders' constant drive for profits ends up rewarding those who bring in short-term profits.

Over time, overconfidence inevitably follows. Caution urged by more experienced hands, who have seen this all before or have at least read their history, is waved aside as the mutterings of a past, discredited generation.

Whether we like it or not, such failures are built in – and indeed priced in – to stock markets. For example, you may have heard before that investing in the stock market over the very long term is actually quite a low risk.

Charts and tables have been used to show that over 20 years an investment in the UK stock market has almost always outperformed a similar investment in cash. Therefore the recommendation has been to invest for the long-term and not to worry about the so-called short-term dips.

The examples of Japan or the United States in the Thirties and Forties are ignored as they inconveniently contradict this view.

But this is only half the story of stock market risk. The longer you invest in the market, then the greater the chance that you will see the market go through one of its catastrophic periods. You can see this feature of the stock market in the price of financial options.

So what does this mean? Should we just hide our money under the mattress? With inflation at 5 per cent that would be far from a good option.

This means that people looking to set aside money for their future need to be smart about it. It means having a well-managed investment portfolio spread across a number of different assets; it means understanding the value of product guarantees over the short and long-term.

It means getting into a regular savings habit and feeding money regularly into the markets through good times and bad.

A regular savings discipline is also a great gift to pass on to children as it should prepare them financially to benefit from and then weather the next inevitable bubble.

But, of course, another thing that history has taught us is that children never listen to their parents.

&#149 Neil Lovatt is sales and marketing director at Scottish Friendly Assurance