MoneyWeek roundup: How to play irrational markets

British economist John Maynard Keynes noted that "the market can stay irrational longer than you can stay solvent". Keynes died in 1946 but events this week have shown that markets are as irrational as ever.

Leading stock indices the world over fell this week after America's Federal Reserve indicated it wouldn't engage in any fresh quantitative easing any time soon. UK stocks received a further blow when the Bank of England revealed something similar on Thursday.

Fair enough, you might say. After all, quantitative easing which involves central banks creating money to buy financial assets pushes up stock prices. Maybe. But the reason both sets of central bankers don't want to print' more money is that the economy, especially in America, is improving.

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So we have the seemingly odd situation where markets fall even as economic prospects improve.

"The news that the real economy might be improving panicked investors", says John Stepek in Thursday's Money Morning. "If that's true, then they won't get any more free money to punt in stock markets."

So why did the Fed shy away from QE3? "There are a number of reasons for this. One of [Federal Reserve chief] Ben Bernanke's stated main goals has been to drive up stock prices, and so make consumers feel wealthier. Given the first quarter rally, he's certainly achieved this for now.

"QE is also politically questionable. We're in the run-up to a US presidential election. It's quite tricky for the Fed to take any steps to boost the economy that aren't easily justifiable. They'll get accused of favouritism otherwise."

That doesn't mean we won't see more money printing in the future, says John, just that stocks will need to plunge before it is rolled out again. And while the US economy looks to be improving, Europe still has the potential to provide the excuse for another collapse.

"Everyone has effectively assumed Europe away into the background. The base case is that there'll be a recession there, but that there won't be a systemic collapse, because the European Central Bank (ECB) will do what it takes to support the eurozone's banks and sovereign governments. I don't necessarily think this is wrong. However, I do think the market is underestimating the amount of pain it'll take to get to that point." Indeed Spain's recent struggles to persuade investors to lend it money show that its debt problems are far from resolved.

The trouble is, notes John, that "second-guessing the actions of central bankers isn't the way to build a portfolio. You need to be aware of these risks and account for them, but I wouldn't sell everything you own and race back into cash".

Instead, John says, you should maintain a balanced portfolio, including exposure to among other things - the US, Japan and a bit of gold as insurance. We look at the case for a US housing recovery in the latest issue of MoneyWeek magazine - if you're not already a subscriber, you can subscribe to MoneyWeek magazine.

Knowing when to stick or twist

Of course, deciding how to balance a portfolio is easier said than done, writes Simon Caufield in the True Value newsletter. Lots of people focus on share selection, but forget that one of the most important decisions is how much of your portfolio you are going to allocate to shares as an asset class in the first place.

The fact is, when a crash comes it wipes out all types of stocks, and you are left wishing you had invested in another asset; say, cash. That might seem obvious but unfortunately a lot of the financial system is geared up to do the opposite, says Simon.

"Most equity fund managers are always fully invested in shares, or close to it. They never question what proportion of their fund should not be in stocks. So they've never developed a way to answer it.

"It's no accident. Most fund managers are primarily investing money on behalf of pension funds and insurance companies. These sophisticated investors make the asset allocation decisions for themselves."

Regulations also ensure that managers stick within the strict confines of their fund mandate. But many private investors don't realise this, says Simon. "They might think professional managers should be better at asset allocation than they are. They might want the manager to switch into cash in bear markets even if it violates the product description. Thanks to regulation, he can't."

Even the independent financial advisors (IFAs) who are meant to advise clients about allocation aren't usually much use. "Thanks to regulation, asset allocation changes cause a lot of admin which advisers don't like doing. So they tend to stick with allocations which they argue are right for the long run.

"In addition, assets like cash, gold and individual bonds, stocks and ETFs don't pay commissions. Most advisers don't tend to tip them. Instead, they recommend funds.

"And that means financial advisers have as much interest in getting asset allocation right as fund managers. None!"

In the rest of the newsletter Simon goes on to explain how investors should decide how much of their money should be in stocks. If you're interested in subscribing to True Value you can send an email to truevalue@moneyweek.com. The newsletter is currently closed to new subscribers, but if you register your interest you'll be placed on the waiting list.

Simon will also be speaking at the next MoneyWeek Conference on 18 May. The inaugural event last year was a great success and we have lined up another impressive selection of speakers this time.

We need to curb executive pay

Another of the speakers at the conference will be our editor-in-chief Merryn Somerset Webb. This week Merryn has been blogging about or rather, against high executive pay.

"I suspect that a good many people at the top of the UK's big banks and listed companies hoped that if they kept their heads down, eventually the issue of executive pay would just go away", says Merryn. Indeed, a recent poll showed that 81% of FTSE 350 directors don't even feel that it's a problem.

Luckily it seems that their ostrich approach to the issue isn't working. "Not only has the issue not gone away but the weekend papers were full of the news that some of our biggest shareholders are finally stepping up to the plate, pointing out that the UK has somehow returned to Victorian levels of income inequality, and demanding action."

Hermes, one of the UK's largest shareholders, has even come up with some suggestions for improvements that it has delivered to FTSE firms. "The document makes the basic point that it is time for the directors of our companies to start thinking more about long-term prosperity for the companies they lead (and by extension our economy as a whole) rather than just about long-term prosperity for the directors", says Merryn.

The report also points to recent research that shows bonuses don't make businesses more successful. Of course, knowing that the level of pay and bonuses for top executives is too high is only part of the problem, says Merryn. The real challenge is doing something about it.

Merryn runs through a couple of the best options in the blog.

A number of you already have, and it seems reader views on bonuses are split. Romford Dave thinks it would be foolhardy to interfere with pay levels. "Why do anything? Haven't we seen enough nose poking interference from successive governments to know that no good comes of it?" He goes on to observe that "raw unfettered capitalism hurts, sometimes".

Yet he is outnumbered by commenters who side with Merryn on the issue. "I don't tend to agree with the assertion the City won't attract the best candidates if there are artificial caps on pay", says Alex. Citing examples such as Goldman Sachs, Alex recommends a 90% tax bracket for "absurd earners". Have your say here.

What is market abuse?

Very high pay packets might not be popular, but they're not illegal at least, not yet. Other aspects of high finance are more of a grey area. This week, MoneyWeek's deputy editor, Tim Bennett, explains the difference between insider trading' and market abuse', and looks at why the Financial Services Authority is getting tough now.

Finally, before I go, a quick word about Twitter. Judging from the mainstream press coverage you might think it is all about digging up celebrity gossip or finding out about which footballer slept with the other's sister, but there's more to it than that.

By following the right people you can get breaking news before it's on traditional news websites. For example the strike against Osama bin Laden was covered by a Pakistani on Twitter before any of the news agencies heard about it. Or you can get analysis on a niche subject.

It's also a pretty good way of communicating with some of the so-called experts in a particular area. And if you are thinking of signing up, I can think of no one better to recommend following than myself (and the rest of the MoneyWeek team, of course).

MoneyWeek

Merryn Somerset Webb

John Stepek

Tim Bennett

James McKeigue

Matthew Partridge

David Stevenson