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Is Caution the New Danger for Markets?

Investing since the start of the credit crisis has often seemed like negotiating a minefield, with hidden dangers everywhere you place your foot. Yet excessive caution could actually be more dangerous at this stage, for both investors and policymakers.

The credit crisis helped fuel a long-term move towards less risky assets, but this kind of caution could in itself be dangerous. As John Maynard Keynes famously said, nothing is more suicidal than a rational investment policy in an irrational world.

“We are seeing excessive caution, born out of fatigue,” Greg Davies, head of behavioral finance and investment philosophy at Barclays, warned in an interview with CNBC.com.

He added: “If you’re investing for the long term, the best thing is not to worry too much about short or medium term movements. The problem is, we all have emotional responses to ups and downs along the way. We are human and we struggle to put short term concerns aside.” (Read More: Emphasize the Downside.)

The swings and roundabouts of the credit crisis have tested the emotional resilience of many — and investors could have been excused for taking a “cash under the mattress” approach in response, he conceded.

“When there are really volatile markets and lots of bad news, this whittles away at the emotional reserves you have to deal with it,” he acknowledged.

Caution in the hands of governments may also be negative for markets, Professor Mark Stein, an expert in the psychology of markets based at the University of Leicester, pointed out.

“The bailouts (in the euro zone) are so massive that they are taking more and more risks,” he told CNBC. “The question is: what kind of risks are being taken to shore up more risk? They’re so keen to avoid short and medium term consequences that they are prepared to build up much greater problems for the future.” (Read More:Risks of Euro Zone Bailout Fund.)

“There’s enormous panic around the euro zone and enormous defensiveness from decision makers. They really can’t bear the thought of looking at the inherent flaws in the currency. The tragic reality is, the flaws are all too evident,” he added.

Stein argued that “group think” has taken over in the single currency area, and singled out Mario Draghi’s recent comments about doing “whatever it takes” to defend the currency as an example of apparent caution leading to more danger.

“You can understand why people say that, but the sad truth is it flies in the face of the evidence,” he said.

The roots of the financial crisis lie in governments enabling banks to take greater risk and increase the correlation between markets as a result of liberalization in the ’80s and ’90s — such as the repeal of the Glass-Steagall Act, which separated commercial from investment in the U.S., according to Stein.

“Liberalization in the ’80s and ’90s just increased that sense of being totally correlated. There’s so much unpredictable risk no matter how cautious you are,” he said.

He is not alone in his views. Even the famed former chief executive of Citigroup, Sandy Weill, who grew the bank to one of the world’s largest following the repeal of Glass-Steagall, has called for some of the regulations to be reinstated following the credit crisis. (Read More: Sandy Weill: Break Up the Big Banks.)

Yet with the risk rabbits out of the bag, the best way of taking advantage of current market conditions may be to keep your nerve and hold on to risk, Davies argued. (Read More: Is The Tide Turning for Markets?)

“The demand for risky assets has decreased, and therefore potential returns might have increased. A long-term view could look like the wrong decision for a long time before a turnaround,” he said. “Good investment returns aren’t just a case of simply knowing what the right thing to do is, it’s a case of being able to stick with it and ignore all the other things clamoring for attention.”

—By CNBC’s Catherine Boyle; Follow Her on Twitter @catboyle01

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