How I've tried to adjust to falling stock markets

When we sold our family house last July to move into something half the size close by, we had surplus cash to invest. That, indeed, was part of our thinking.

When we sold our family house last July to move into something half the size close by, we had surplus cash to invest. That, indeed, was part of our thinking.

Like so many people whose children had left home, we had looked upon our house, which was now too large, as a sort of pension scheme. But how would it be best to invest the money we had released?

At the time, I was convinced that deflation was the major threat facing the advanced economies, and I still am, with qualifications. That apprehension meant that I didn't really consider investing in ordinary shares.

For Japan provides a dreadful warning here. It has suffered deflation for three or four years, and among the many consequences is the weak behaviour of its stock market. Share prices are at their lowest level for 18 years. Deflation is very unkind to companies with large amounts of debt, and the Japanese stock market has many examples. It is not alone.

If one absolutely believes that deflation is coming, then it is absolutely clear what one should do. Purchase fixed-interest securities issued by the British Government that are not due to be repaid for a long time. Such securities would once again earn their old reputation for being "gilt-edged". This is because the fixed income stream they provide would become steadily more valuable in purchasing power as consumer prices declined.

I therefore bought the longest-dated government security in the list that I could find – a stock yielding 4.5 per cent and not repayable until 2032. By that date, I reasoned, I probably wouldn't any longer be writing articles in The Independent or worrying about my pension. I sat back.

My holding went up a little, then fell back, jumped again, retreated once more before bouncing, even falling below my purchase price for a week or two, and in this fashion grew fitfully in value. Nonetheless, I slowly began to reconsider the choice I had made.

It swiftly became obvious, first of all, that I was sitting on a sort of see-saw. When equities rose, government securities fell, and vice versa. I hadn't just taken a view on deflation, I had also taken a more definite decision about the prospects for equities than I had at first realised.

Secondly, I began to understand more clearly that the UK was probably the least likely of the major economies to experience deflation. It would reach Germany before us. The US, too, might be ahead of us in the queue. This is because our large service sector appears to have the ability continually to raise prices – by 4.8 per cent in 2002, as last week's statistics showed, even though goods prices actually fell by 2.1 per cent during the same period.

And thirdly, purely as a holder of government securities, I was unpleasantly surprised by the large rise in government borrowing which is under way. As a result, investors may be offered more stock than they really want, and prices will fall.

At the same time, as Christmas approached, the level of uncertainty in financial markets on all counts became higher than I had known it in 40 years. This was mainly because of Iraq, although the behaviour of the American economy itself was giving conflicting indications. I could simultaneously plot two contrasting scenarios.

In scenario A, there is either no war, or a swift victory for the US and its allies. Consequently oil prices drop smartly, gold loses its shine and economic expansion resumes. As this happens, equity markets jump 20 per cent or more and investors dump government securities. In scenario B, Iraq is invaded but local resistance is much stronger than expected and memories of Vietnam flood back. In these circumstances oil prices would stay high, consumer confidence would be badly dented and a full-scale recession would set in. I don't need to spell out the impact on the stock market.

Again I felt sure what to do, even though my previous conviction regarding deflation had lasted barely six months. Sell my government securities, fortunately at a modest profit, and put the funds on deposit. I made the switch on Christmas Eve. It is the classic response to extreme uncertainty, as is the sharp rise in the price of gold, and it explains, I think, the unprecedented 10-day, non-stop decline in equities which had been recorded up to the close of trading on Friday evening. London has dropped even further than New York or the continental bourses because international investors have become uneasy about the speculative bubble in the British housing market.

When the mist has finally blown away, when visibility returns and one can once more make some estimate of economic possibilities, will I go back into government securities? Maybe, but on balance I don't think so.

I may well become attracted by equities after a long period of disenchantment if prices remain subdued. Not for 50 years has the dividend yield on a holding of typical equities, at nearly 4 per cent, been so close to the return on government stocks. Many professional investors would take the coincidence of the two rates of return as a signal to buy equities. Unless I remain seriously concerned by the possibility of deflation, I may be tempted to do the same.