By Dr David Clark

The recent machinations on global equity markets were a long overdue reminder that it is the unknowns - the ones we don't know - that matter.

Financial markets, far from being "perfect" and rational, by always anticipating the events which move them, are in fact highly imperfect and irrational.

Moreover, financial markets are very different to goods markets for two main reasons.

The first is that supply does not simply adjust to changes in demand.

In goods markets, a sharp fall in demand can produce a fall in prices and then supply. But in financial markets, as we saw recently, a sharp fall in share prices does not see a sharp fall in supply.

This is because financial markets, unlike goods markets, really do not have a supply side, as the majority of trades involve the exchange of existing, second-hand shares.

The second main difference between goods and financial markets is that when one buys a good it is much easier to place a value on a good than a financial product, because one only has to decide what the good is worth to you now.

With a financial product, you have to decide what the product will be worth to someone else, some indefinite time into the future.

In other words, by their very nature, financial markets have much more uncertainty and thus, not surprisingly, much more volatility.

Human beings thus have no choice but to try and work out what their fellow investors are going to do - and then try and follow the herd.

The trouble is most other members of the herd do not have any more information and certainty than any other herd members.

Yet, as we have seen in recent years, rising markets encourage herd members to think that some members in the herd must know something they don't and they thus join the stampede.

They adopt a "safety in numbers" approach. But like lemmings, what they think is the right thing to do because many others are doing it, can turn out to be disastrous.

Conversely, falling markets can produce panic sell-offs, which greatly exacerbate price falls.

In short, investor sentiment is very much a product of changes in perceived market "moods", which are not based on anything like perfect knowledge or certainty.

Hence, the wild swings in financial markets.

Uncertainty has also been increased by the greater use of much more sophisticated financial instruments: for example, securitisation.

This refers to the practice of bundling sub-prime mortgages, which are loans to less credit-worthy borrowers, into separate securities that are then assigned a rating by an agency and resold to investors around the world.

However, the risk profiles of such instruments are very difficult to determine, even by the most experienced ratings agencies.

Last month's disclosure of previously unsuspected levels of risk in US housing loans, which set off the sharp equities fall, was a good example that the key "facts" are often hidden from even the most sophisticated market players.

Uncertainty is also worsened by the fact that investors - and their advisors - also have far from perfect memories.

For example, last month's credit crunch had plenty of precedents.

We had one spurred by high-yield bonds in the late 1980s, followed by the savings-and-loan crisis of the early 1990s, the Long-Term Capital Management fiasco, the Asian crisis in 1997 and 1998, and the bursting of the Internet bubble in 2000 and 2001.

Indeed, we should expect one every five to 10 years, if recent history is any guide.

In short, last month's sudden disclosure of the extent of risky lending in the US, which forced lenders to re-assess risk profiles and raise interest rates, was a salutary and overdue reminder of the key importance of uncertainty in all financial markets - something which is simply forgotten by most investors during periods of prolonged upswing.

Most importantly, it was also a reminder of three key things in a world of great uncertainty: the dangers of "short-termism" - of making investment decisions based on the latest headlines from the financial pages - of the need to hold a diversified portfolio, and of the attractiveness of indexed funds.


Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed are those of David Clark's, not necessarily those of Vanguard's.