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Risk is the word

Last week was certainly a rollercoaster ride for those in equity markets. Risk is suddenly on everyone’s lips.

Let’s face it, investors had been lulled into a false sense of security by three years of rising equity markets and the escalation in value of a number of other asset classes, notably housing and commodities. But perhaps the most interesting aspect of what has been happening to share prices over recent weeks is the way in which much of each day’s movement has been condensed into the last hour or so of trading.

Unsurprisingly, derivatives have been blamed. This is not a fanciful idea. Not only has the growth of hedge funds increased the use of these instruments but the practice of financial institutions using them as part of their risk-control mechanisms is increasing the velocity of trade. Several years of low volatility has lowered the cost of using these instruments. It is ironic that not only are they now compounding the wild swings taking place in share prices but this greater volatility is also driving up the cost of using derivatives.

Meanwhile, the OECD has come out with some optimistic noises on the health of economic activity in the developed world. In the twice-yearly Economic Outlook, published last week, this Paris-based thinktank forecasts growth of around 3 per cent for its 30 member nations for this year and next. True, it expects a modest slowdown in 2007 but not sufficient to set alarm bells ringing, while 3 per cent growth seems hardly likely to lead to a bout of further aggressive monetary tightening.

So what is the market getting its knickers in a twist about? It appears to be little more than the indiscriminate rise in the value of certain asset classes. As an example, the rush to commit cash to shares and bonds from emerging markets led to a rise in their relative valuations that left too little to chance. Little wonder that these have borne the brunt of the sell-off. But it remains to be seen whether there is not more to come. A far better game to play in these markets is to find those investments dragged down by the loss of sentiment but without the inherent valuation risks attached.

A further interesting aspect of these recent developments is the way in which they have been widely forecast. There is evidence that some of the investment banks have been building teams to exploit the opportunities that will undoubtedly arise if the going remains tough. The world has become faster moving and more efficient than it would have been possible to forecast even a comparatively short time ago.

An example of this is in the field of distressed debt. This somewhat esoteric area of financial activity is seeing a number of firms increase their capacity to take advantage of any rise in the level of corporate bankruptcies. What, I wonder, does this tell us about the outlook for the future? Probably no more than that business cycles do still take place and that being prepared is no more than common sense. This is advice that portfolio planners should take to heart.

Few private investors are likely to find holdings of distressed debt in their portfolios but the availability of options to broaden the spread of risk is greater now than it has ever been. Now is the time to check that those boring areas, like equity income or the value and defensive sectors, are fully represented.

Markets will continue to fluctuate but my money is on the FTSE 100 index finishing the year at a higher level than at present. It may not top the recent peak but, barring accidents, the case for equities remains undiminished overall. It is just that a greater awareness of risk has been engendered by recent events. The caution that this has introduced into the approach of a wide range of investors will take a little while to disperse.


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