What Causes Instability in Investment?

Instability in investments normally means a great and disconcerting volatility in the rate of return. Unstable investments most often derive from financial instability in general, though more “micro” level factors, such as incompetent management, can play a role. When speaking of “investment instability,” it is normal to speak in more “macro” level terms that can and do have a direct bearing on micro-level investment problems.

Professor Barry Eichengreen of the University of California at Berkeley summarized four specific causes for general, macro-level investment instability. These four are applicable to both domestic and foreign situations. The first is the instability of the macroeconomic system in general. This can take the form of high government indebtedness, large trade deficits, inflationary pressures, lack of credit and a lack of faith in the economy by investors. Many of these macroeconomic problems can lead to a currency with a value that is always in doubt, rendering investments continually volatile.

Eichengreen cites, secondly, the fragile nature of the financial system as another major, macro-cause of investment instability. In places like South Korea, a great dependence on short-term bonds and other debt funding has rendered that economy very vulnerable to speculative pressures. This is precisely what happened in 1997, when George Soros' speculation on the Thai currency had repercussions throughout Asia. High debt is one of the most significant causes of financial market fragility.

Institutional weakness is another major cause of investment volatility and instability. A weak state often cannot oversee the money markets and other forms of investment. Strong states like China control their currency and markets directly, and, as a result, China was able to survive the 1997 Asian crisis. At the micro-level, a lack of accountability of the board and management to stockholders can lead to poor management that can harm stock value, and harm it quickly.

The international market itself can become a major cause of investment volatility. Speculation can create bubbles that dangerously overvalue assets such as real estate. Eventually, that debt bubble will burst, as one cannot forever borrow from one to pay another. This leads to a quick crash and the potential destruction of an entire economy. High debt in a major market, such as the American or European market, can also create investment volatility, since many investors begin thinking that these markets cannot be in high debt forever. Eventually, when the bill comes due and credit has become very expensive, the market is no longer able to absorb the productive capacity of the country.