Crash Course

John Lim

THE JAPANESE JUST “celebrated” the 30th anniversary of their stock market’s peak. The Nikkei 225 hit an all-time high of 38,916 in December 1989. Today, it stands at 23,320, or 40% below 1989’s level.

“But the Japanese stock market in the 1980s was the mother of all bubbles,” you might respond. Perhaps. But what about the Nasdaq bubble of the late ’90s? True, the Nasdaq Composite Index has finally returned to its 2000 peak. But it took 15 years.

By contrast, it’s been 30 years since Japanese stocks last recorded a new high—close to an investing lifetime. Imagine the pain of a Japanese couple who started investing in 1989 and have yet to make any money after three decades. The Japanese experience may be anomalous. But I believe it can teach us five valuable investing lessons.

1. Geographical diversification is imperative. I disagree with the late Jack Bogle, who didn’t believe that U.S. investors needed to diversify globally: “I don’t quite understand where this thing is that you must have a global portfolio. Maybe it’s right. Of course, maybe anything is right, but I think the argument favors the domestic U.S. portfolio.”

Bogle goes on to mention how the U.S. has so many advantages in terms of entrepreneurial spirit, sound institutions and solid governance. The problem is, many people were also singing Japan’s praises in the 1980s. Markets reflect that sort of information. If U.S. companies are felt to be dominant and have intrinsic advantages, that’s already priced into their stocks.

I’m not saying that the U.S. is like Japan. But I also don’t know that what happened to Japanese stocks could never happen here in the U.S. Those who believe otherwise need a dose of humility.

2. Bonds still play a role in portfolios. The great Benjamin Graham warned against having more than 75% of one’s holdings in stocks. While some may consider his advice antiquated, I believe it’s prudent.

If the Japanese experience teaches us anything, it’s that stocks can be incredibly risky. A Japanese investor who had some portion of his or her holdings in bonds fared far better than one fully invested in stocks. If nothing else, it would have allowed him or her to sleep better at night.

Bond yields around the world have never been lower and, indeed, many are negative. This has prompted some to question whether bonds still make sense. The answer is an emphatic yes, but with a key caveat: Since the role of bonds in portfolios is to provide ballast and diversification, “reaching for yield” by taking greater credit and duration risk for incrementally higher returns is probably unwise.

3. Risk tolerance is shaped by our experiences. The average Japanese household stockpiles cash to the tune of over 50% of their financial holdings. This compares to just 14% for U.S. households. While there are probably numerous reasons for Japan’s cash obsession—including cultural reasons, deflation and low financial literacy—the terrible stock market performance of the past three decades is no doubt a major factor.

If we want to be successful investors, we must guard against risk tolerance “drift.” In a protracted bull market, we need to be careful not to allow our risk tolerance to creep higher—and we might even want to ratchet it down a notch. Similarly, we also need to guard against allowing our risk tolerance to plummet during bear markets.

4. Never say never. I believe strongly that, to be a successful investor, we need to know our financial history. In the words of George Santayana, “Those who cannot remember the past are condemned to repeat it.” That said, it can also be a mistake to extrapolate history too far.

For example, there has never been a 20-calendar-year period of negative stock market returns for the S&P 500. (Clearly, the same cannot be said for the Japanese stock market.) Could this rule be violated some day? Of course, it could. The question to ask yourself is this: Would my portfolio and the financial future it represents be okay in the event that the next two decades result in zero or negative returns for the U.S. stock market?

5. Mean reversion is real. The stock market wasn’t the only bubble in Japan in the late 1980s. Real estate in Japan also soared. At its peak, it’s estimated that all of the land in Japan—geographically slightly smaller than California—was worth $18 trillion, or almost four times higher than the value of all U.S. real estate at that time. Mean reversion—the tendency for bad times to follow good and vice versa—almost guaranteed that future returns for the Japanese stock and real estate markets would cool from the lofty levels of the late 1980s.

Sophisticated investors can estimate the expected long-term returns embedded in stock prices using the dividend discount model. Applying that model to today’s U.S. stock market is sobering. It implies future returns that are barely above inflation. By contrast, the outlook for international stocks is much brighter. After inflation, emerging markets could deliver an annual, after-inflation return of close to 7%.

The lesson is clear: Trees don’t grow to the sky. It’s a huge mistake in investing to extrapolate the past into the future. In fact, doing the opposite will usually get you closer to the truth.

John Lim is a physician and author of How to Raise Your Child’s Financial IQ, which is available as both a free PDF and a Kindle edition. His previous articles include 12 Financial Sins12 Investment Sins and How Low? Too Low. Follow John on Twitter @JohnTLim.

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