7th December 2011 by The Value Perspective
By Kevin Murphy.
One element of psychological baggage most investors bring with them to the stockmarket is a fondness for thinking in terms of ‘simple stories’. Rather than understanding the complex tapestry that is markets, valuations and economics, some prefer to reduce everything to simpler ideas with which they feel more comfortable.
An obvious example of this from the last 12 months or so has been the market’s love of the so-called ‘risk-on’ and ‘risk-off’ trades. Markets going up? Increase risk in portfolios. Markets going down? Cut back the risk. Everyone can understand simple stories such as that and so they stop worrying about the underlying logic and, often, whether they are even right.
Take a simple story that is prevalent in the world of sovereign debt – countries are like dominoes and once, say, Greece topples over, others must necessarily fall too. But what if this is overly simplistic and one country could fall without bringing down any others? What if a better analogy was a forest fire and the European Union, European Central Bank and International Monetary Fund are looking to build a firebreak big enough to stop the fire spreading elsewhere?
Looked at in terms of European GDP, Greece is tiny, accounting for just 2.5%. Few banks – and certainly no major ones – have sufficient exposure to the country to cause a problem in itself. No UK bank has any exposure to Greece that would cause it even to blink in the event of a debt default.
However, investors have become fixated on the question of which country might be the next domino to fall. To their mind, it cannot just be Greece – it has to be Portugal, then Ireland, then Spain, then Italy, then Belgium, then France … and then we are all in real trouble.
For many, the end result of such thinking is they would rather take the certainty of negative real returns from cash ahead of the short-term uncertainty. However, what history would suggest, starting with valuations where they are today and on a three or five-year basis would be very positive real returns – albeit with possible further short-term falls – from equities.
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