Some financial experts who know the history of U.S. markets inside and out are nonetheless oblivious to the history of stock markets around the world. This has always puzzled me. Do these other markets have nothing to teach us?
Stock market history is a valuable field of study, but sloppy or biased history can deceive us and give us false hope about our investment future. We need to be careful about which market historians we follow. Analysis of market history must be objective, and must not focus on markets or time periods that create unrealistic expectations, and thus false hopes.
With such a limited market history, it surprises me that so many historians have decided to ignore one of the largest markets in the world: Japan. The world’s second-largest economy contains vital lessons which American investors would be wise to heed, but that history is rarely examined in this country. Is it because the story it tells doesn’t support a passive investment philosophy?
Markets exhibit a high degree of randomness. We should remind ourselves that a single time series only tells us about one of an infinite number of potential outcomes–I call them alternative histories. A lone set of outcomes is all history provides, so we must examine it carefully. Moreover, we shouldn’t consider just those slices of history that provide the most pleasant results: We must be aware of the alternative histories that didn’t take place but could have. Monte Carlo analysis, although it isn’t perfect, is an excellent tool for studying alternative histories.
If we seek integrity as a researcher or market historian, we can not discard histories (actual or alternative) that fail to provide the outcomes we want. Research is all we have when it comes to forming reasonable assumptions about future markets.
Although this seems obvious, it is worth stating–we have to understand that future events will differ from the past. History may be a rough guide, but it is far from a reliable map. History shows us what stocks have done, but it’s the critical interpretation of that history that influences our investment decisions.
Because understanding the lessons of market history is a much more complex task than many would have us believe, much of what we learn about market history depends on the historian–and that’s potentially dangerous if the historian is biased or ignorant. Be skeptical of the market historian whose goal is to sell a product or a service. Ask yourself if they have a conflict of interest. In fact, every market historian should be read with a healthy dose of skepticism.
Stocks for the Long Run?
The Tokyo Stock Exchange (TSE) was established in 1878, about sixty years after the New York Stock Exchange (NYSE) adopted its first constitution. In 1943, the TSE merged with 10 other stock exchanges in major Japanese cities to form a single Japanese Stock Exchange. By 1990, stocks on the TSE accounted for over 60% of the world’s total stock market capitalization, making it far and away the biggest stock market on earth at the time.
The last two decades, however, have been disastrous for anyone holding Japanese stocks. Between 1989 and 2009, the Nikkei 225 Index lost 82% of its value. In other words, a $100,000 investment made 20 years ago in a fund that tracks the index was worth about $18,000 in March of last year. Since then the index has rallied 52%, but it is still down over 73% from its 1989 high. Today, the Japanese stock index still needs to climb an additional 164% to return to that 1989 high.
If you were a 40-year-old investor in Japan in 1980 and used a buy-and-hold strategy, in March 2009, at age 69, you would have had a portfolio worth less than what you started with nearly 30 years earlier.
Your run-of-the-mill market historian might say, “Okay, that’s Japan, it’s a much smaller economy,” completely unaware of, or disregarding, the fact that the Japanese stock market was the world’s largest 20 years ago. In economic terms, Japan certainly is no slouch. Even today the Japanese economy is second only to that of the U.S.
If this example doesn’t suggest to you that buy and hold is crazy, maybe a picture will help.
Doug Short (www.dshort.com) is one of the most dedicated and intelligent stock market historians I know. He studies markets like teenagers study television. I asked Doug to create the table below and the following chart, so we can examine the once-mighty Japanese market.
Still Hanging On, But Why?
If you are wondering why some investors are still hanging on in Japan, you are asking the right question. The Nikkei’s 20-year decline has been anything but smooth. As we can see, the index has gyrated all over the place, giving the passive investor fits.
Amid the long-term slide, there were bright spots. The table shows each of the bear market rallies since the 1989 high, and we can see that five of the six rallies were over 50% and one added 135%. Each one could have been the start of a new bull market, but no–five would-be bottoms proved to be mere interludes before the pain resumed, and hope kept stubborn investors frozen as their wealth continued to erode.
Here’s one interesting sociological result of the Japanese market’s behavior: Japanese investors have one of the highest rates of life insurance in the world–Research magazine estimates that 19 out of 20 Japanese households have acquired some form of life insurance. Japanese investors are far more risk averse than their American counterparts. Now we can see why.
Japan’s woes came about thanks to an overheated housing market, cheap credit, and mountains of bad debt. Sound familiar? Their bankers made many of the same mistakes that ours have in recent years, giving credit to undeserving customers.
So, if you are beginning to think there is something valuable in observing Japan, you can understand why I’ve been puzzled as to why most market historians have carefully avoided this huge marketplace. While it isn’t pretty, there is certainly a lot to be learned.
No Guarantees, No Matter How Long You Wait
Stocks have no borders on extremes. They can grow as high as the sky, or they can become worthless. As human beings, we find that discomforting. We would like to believe that our financial future is certain, or at least that the odds are stacked heavily in our favor.
We tend to believe what we want to believe. In fact, we are all biased, and the best we can do is to recognize our weaknesses and use that understanding to our advantage. I frequently remind our investment team here at Schreiner Capital Management that, “We’re a bunch of ignorant human beings. Be glad we know it, because it gives us an advantage over the average market participant who is woefully arrogant and overconfident.”
Despite what we hear from the media and retail-oriented firms on Wall Street, there is no guarantee that stocks will provide a positive return, no matter what our time horizon. With the constant barrage of new economic data, global political events, systemic risks, government intervention, natural disasters, and terrorism, our financial system will inevitably experience additional shocks; the only question is when they will occur.
Today, more than ever, global markets are dynamically linked. Foreign markets affect ours, and ours affect theirs. One lesson we learn from Japan is that even the largest stock market in the world is not immune to disaster. History teaches us that anything can happen, and it will, eventually.
Real World Investing
You don’t have to be a market historian to know that stock markets are risky. But proponents of buy and hold would rather that you not focus on the stock market in Japan, or anywhere else for that matter. After all, the history of the U.S. stock market reads more like a romance novel, if you ignore a few of the most recent chapters, and that’s the story they would much rather tell.
History supports the idea that buy-and-hold investing is unlikely to provide acceptable returns. Wishful thinking and cherry-picking slices of market history that support passive investing are the only ways Wall Street can justify exposing investors’ assets to a passive philosophy.
For many investors and advisors who grew up in an environment skewed toward the investment philosophies of the big mutual funds, it is a huge mental leap to repudiate their buy-and-hope approach. There is, however, a significant movement to re-educate investors to the proactive approach after a decade of negative returns here in the U.S. Recent events indicate that it may have been wishful thinking to assume that traditional, passive investing would survive in a world of great uncertainty.
One look at the repeated rallies and declines in the Japanese stock market over the last thirty years shows incredible opportunities for active investors. Yet the same graph shows how cruelly investors were treated if their investment philosophy was passive.
A Journey, Not a Destination
Risk management is not something you do for a while and then stop. I believe the evidence is clear that an active investment process is an absolute necessity to survive in today’s uncertain world. Unfortunately, there isn’t a permanent allocation that will defend your clients against losses and grow their assets at a rate that meets their retirement needs. To protect your clients from the unknown, you are going to have to be proactive or find a portfolio manager who can navigate these volatile markets with you.
Asset preservation should be your primary objective. Don’t just take my word for it. Study history.
Roger Schreiner is the founder and CEO of Schreiner Capital Management, Inc. (SCM), an SEC-registered investment advisor located in Exton, Pennsylvania; he can be reached at [email protected]. SCM is a third-party investment manager and sponsors the Select Advisors Wrap Program ( www.selectadvisors.com), an investment platform that provides active investment solutions for RIAs and their clients.