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When sharemarkets and the real world collide.
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When sharemarkets and the real world collide.

By Robin Bowerman
Smart Investing
18th  September  2008
Principal & Head of Retail, Vanguard Investments Australia

The relationship between the real world and the stockmarket can sometimes seem tenuous.

The rout on financial markets is inescapable yet people are still going to work earning money, going to the supermarket or the pub to spend it, buying fridges, TVs and even luxury cars. Spring is in the air and football finals fever is building. In short life goes on.

So reconciling what is happening with sharemarkets around the globe and trying to comprehend the mind-bending numbers that are tossed up regularly in the media about the size of losses or asset writedowns is far from a straightforward exercise.
For the person on the street it is not surprising if the problems besetting Wall Street investment banks seem a long way from real-life in downtown Australia. With the obvious exception of the bank employees who have dramatically lost their jobs the gyrations of the sharemarket can appear strangely disconnected from everyday business.

With words like crisis, panic and financial contagion bombarding us via newspapers, websites and nightly TV radio and news broadcasts it is no surprise that consumer and investor confidence has taken a battering and for the first time in 20 years bank term deposits top the rankings in consumer surveys as the wisest place to invest.

So the need for context - and a clear head - has never been more important. We know from previous market corrections/crashes that making emotional decisions in the heat of short-term events can simply turn bad to worse.

So a critical issue is whether you believe the financial market gyrations are a portent of bad things to come in the real world economy or that over time as confidence returns in company earnings that the sharemarket will return to realistic valuations based on the long-term growth in both our economy and more broadly the global economy.

There is no doubt the financial sector - notably US investment banks - have done a spectacularly good job at distancing themselves from the real world. Amazing profit growth within what has been dubbed the "shadow banking system" in recent years has been exposed for what it is - increasing amounts of poor grade debt bundled up in a way that disguised or at least obscured the true level of risk.

Now the default risk is there for all to see suddenly we are faced with a system that is seizing up on itself. It's akin to driving a car with a fine engine but a gearbox that is struggling to engage the right gear. Repairs - be it via regulation or markets forcing mergers and takeovers - will clearly be required.

Yet there is plenty of good news around on the economic front: oil and food prices are down from their mid-year highs; the US economy seems surprisingly strong (the US economy had the strongest growth of the G7 countries for the June quarter) while unemployment rates - a critical economic indicator - both here and in the US are at low levels.

In the Australian economy the Reserve Bank governor Glenn Stevens reported to Parliament this week that domestic demand in Australia rose 4% in the first six months of this year - down from about 5.5% last year. That is in itself good news because it takes the pressure off inflation from the Reserve Bank's perspective and in turn gives them the flexibility to lower interest rates.

So the economic scorecard paints a much more positive picture than the daily gyrations of sharemarkets. But for investors who are receiving super fund statements or checking account balances online that will be cold comfort. And there are lessons - albeit painful ones - to be learned from extraordinary periods like these.

With all the market activity swirling around us the hardest thing can be to sit still and do nothing. Now if you are young and you are invested in a diversified portfolio in your super fund it should be easy to file the statement and write yourself a note to check back around the same time next year. If you are older, perhaps approaching or in retirement the challenge may seem several orders of difficulty higher.

But at times like these diversification - spreading your money across a range of investments, a number of asset classes and over time - is the best way to handle the risk.

Australian shares - as measured by Vanguard's Australian shares index fund is down 14.7% for the 12 months to the end of August. In contrast the diversified balanced index fund is down a much more modest -4.7% for the same period. No-one likes negative numbers but that really shows the power of having a portfolio that has a good level of exposure to fixed interest and bonds as your defensive asset mix.
The other perspective is to remind yourself that when you are investing in the sharemarket - and particularly with super - you are investing for the long-term. Looking over five years the Australian share market index fund has grown 14.3% a year to the end of August. If someone had told you that was the return you would get five years ago most people would have signed up happily.

When it comes to what happens next in the short-term your guess is as good as the next person's. What a review of financial crises and crashes back to the 1929 Wall St crash does tell us though is that they are typically caused by some speculative build up which is where markets and the real world economy tend to part company. After the bubble - and the seemingly inevitable hangover - the real world economic value can again be seen more clearly and normal cyclical service is resumed.