They say that one should always avoid speaking of politics and religion in polite conversation. Ostensibly this is because people hold such strong opinions on these topics, and understandably avoidance is a wise course of action if one wishes to avoid argument and confrontation. To this list I would add investment philosophy, as this too is a highly polarising topic which seems to engender very strong emotions.
As an advocate of the long term approach I am certainly well aware of this, particularly as a writer in a trading newsletter! Nevertheless, I believe the best one can do is take an evidence based approach and let the facts speak for themselves. To that end, this week and next I want to tackle one of the most credible arguments against long term investing: the Japanese experience. While many criticisms against long term investing are easily dismissed, the performance of the Japanese market over the past 20 years is much more difficult to ignore: since 1989 the Japanese market has dropped by approximately 69%.
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Clearly this seems to be a terrible outcome for long term investors, but we need to not only contextualise this performance but also understand that long term investing, contrary to popular belief, involves far more than simply ‘buy and hold’. If we acknowledge this and introduce even some very basic investment techniques the result is one which may surprise you.
Before we get into specifics, the first point to make is that the Japanese market is the only example of a major industrialised nation to exhibit such poor long term performance in the modern era. I would argue if the long term approach has been successful in 95% of cases, it can hardly be labelled as ineffective. If you had a technical indicator that was correct even 70% of the time it would be considered very powerful indeed. The fact is that if the long term investing approach was completely ineffective, you would imagine that there would be a long list of examples of its failure, not just one or two. (I won’t discuss the other oft quoted examples, such as the oil crisis of the 70’s or the ’87 crash as none are as severe as the Japanese example and furthermore the arguments I will discuss here are for the most part equally relevant to these other periods.)
Rather than just chalk up the performance of the Japanese market as the exception that proves the rule, I would go a step further and suggest that things aren’t nearly as bad as they appear. For starters Japan has barely seen any inflation over the past 20 years, and indeed suffered substantial deflation during the ‘lost decade’. As most would know, inflation acts to reduce the spending power of money. The flip side of course is that deflation will increase the value of the currency. So whereas the true or ‘real’ value of money has decreased for most other nations, in Japan it has essentially remained the same. This means that in real terms the decrease in market value is substantially less than would have otherwise been the case in an inflationary environment. Granted this is of little solace as even in real terms investors have lost around 70%, but the point is that if Japan had experienced a similar rate of inflation as Australia the loss in real terms would be closer to 90%.
A much more important factor is that we are almost exactly 20 years on from the absolute height of the Japanese market. The 20 years preceding the 1989 top saw the Japanese market rise a staggering 1588% as it underwent a massive transformation to become the second largest economy in the world. Towards the end of this time, fantastic bubbles developed in asset markets which significantly over inflated prices. The point is that if you buy at the height of a bubble, especially one as staggeringly large as in Japan, it will always take you a long time to recoup your losses (especially if you just sit on your hands and wait). Clearly, it doesn’t make sense to only choose the summit of market bubbles as the starting point for measuring performance.
If instead you missed the absolute high, which the majority of consistent long term buyers would have, the situation becomes much less disappointing. If you had invested only 3 years after the high you would now be sitting at 33% loss. Of course that’s still pretty poor, but nevertheless it is a significant improvement. Move further away from the market peak and the picture continues to improve. Indeed, you could even nominate a number of periods over the past few decades which would have led to attractive long term gains.
As you can see, a retrospective approach will allow you to paint the picture as you choose. With the benefit of hindsight you can make even the Japanese market seem reasonably rewarding! I acknowledge this, but I want to ensure that readers understand that the reverse is true; that is, by choosing the very top of the largest asset bubble in the modern era you can easily make things seem absolutely terrible.
Granted, to this point, all I have done is contextualise things and sought to explain away the situation as an anomaly and a factor of bad timing. Undoubtedly this will fail to change most reader’s perceptions, and understandably so. Next week, I will redress this and demonstrate how some of the most basic principles of investing could have actually led to an attractive outcome.
Make the markets work for you!