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Investment horror story: the Japanese stock market
September 22, 2018
Investing done right should be straight forward and, over the long term, profitable. However, it is also important to consider where it can go wrong. There are instances where investors lost their savings in a stock that went bankrupt. Sometimes, it could be a whole category of assets that goes down at the same time. Other times it could be a fund or a strategy that was wrong or inappropriate. Investors can also be sold products with high fees, no transparency or, infamously, be victims of fraud. It is important to be aware of what kinds of disaster scenarios can occur and what lessons, if any, can be learned from these.
One of the biggest investment horror stories in recent memory has been the implosion of the Japanese stock market. Investors are taught that stock markets go up over the long term, however this case is a huge asterisk to that assertion. At the end of 1989, the Nikkei 225, the most commonly cited stock market index for Japan, peaked at a value of over 38,900 points. Over the course of 1990, as the Japanese real estate market weakened, the Nikkei dropped in value by over 40%. Then it continued to go down throughout the 90s and 2000s, with a few upswings that never lasted. By the end of 1992, the index was down to 16,000. In 2003, it had crumbled to 7,800. It recovered slightly, only to be sideswiped by the global financial crisis, reaching a low of 7,500 in February 2009. In 20 years, the Japanese stock market lost 80% of its value. Even today, the index is around 23,000, barely more than half where it was almost 3 decades ago. Stocks for the long run? Go tell that to the Japanese!
This incredible drop in Japanese stocks came right after a period of equally incredible positive returns. From the end of 1982 to the peak in 1989, the Nikkei returned an average of 25% per year. 8 of the top 10 companies in the world by market capitalization were Japanese, as were 9 of the top 10 banks by assets. The rise of the stock market reflected an astonishing real estate bubble. It was fueled by extremely high levels of debt provided by banks and other financial institutions. At its height, the Japanese real estate market was worth 4 times as much as the entire U.S. real estate market. The grounds of the Imperial Palace alone were valued at more than the real estate of California or Canada. The abysmal performance of the stock market is a direct consequence of those speculative bubbles finally exploding.
There are a couple of lessons that can be learned from the Japanese experience. First, valuation matters. At its height, the Nikkei’s value was 60 times earnings, meaning Japanese stocks were priced as if they were worth 60 times their profits. Even at the peak of the tech stock bubble in the late 1990s, U.S. stocks were trading around 30 times their earnings, and a more normal number would be around 15-20 times earnings. When stocks and especially the stock market as whole are at such expensive levels, poor long-term returns are generally follow. Secondly, more importantly, diversification matters. The incredible returns generated by the Nikkei meant that the Japanese stock market alone made up almost half the value of the stock markets around the whole world and was far bigger than the U.S. stock market. Investors around the world tend to be overinvested in their domestic companies and that certainly would have been the case for Japanese investors. It’s a phenomenon called “home bias”.
Even from the perspective of North American investors, investing in the stock markets beyond our oceans would’ve likely resulted in an extremely heavy concentration in Japan and affected non-North American returns. On the other hand, spreading investments over geographies and asset classes would’ve reduced the impact of bad returns in one area. Even as the Japanese stock market has gone from low to lower, Japanese government bonds returned about 6% per year between 1990 and 2015. As mundane as this advice sounds, it is better to not keep all your eggs in one basket.