Lessons From Japan's Great Depression

Alexander Green
by Alexander Green, Chief Investment Strategist

Lessons From Japan's Great Depression

by Alexander Green, Investment Director

Friday, March 6, 2009: Issue #950

Monday I wrote about investment lessons from the Great Depression. Chief among these is that if you bought stocks after the Dow declined 50% from its 1929 peak, you did very well in the decade ahead, even though stocks continued to fall for the next 18 months.

In the decade from January 1931 to January 1940 - amidst the worst economic stretch in our history - bonds, real estate, commodities and cash all lagged the long-term performance of the Dow with dividends reinvested.

That's a surprise to most investors - and a head's up to those wondering what the heck to do with their money now that the Dow has lost half of its value.

But what about the other Great Depression, the recent one in Japan? In 1989, the Nikkei 225 traded above 40,000. Today it languishes near 7,300, 82% lower.

What Investor's Can Learn From Japan's Long Deflation

In many ways, Japan's long deflation has been different from the United States in the 1930s. There have been no breadlines - or 25% unemployment.

Yet an 82% decline in the market over two decades is devastating even to investors with the longest time horizons. Bear in mind, this example excludes dividends. But still, this is an astonishingly poor performance. What can we learn here?

(Very little from Dr. Jeremy Siegel, incidentally. I pegged him at an investment conference last year for publishing the fourth edition of "Stocks for the Long Run" with nary a word about Japan's horrendous performance over the past two decades.)

The first lesson, one that becomes increasingly crucial with age, is the supreme importance of asset allocation. A 100% stock portfolio, in my opinion, is too risky for even the hardiest of souls.

I've been saying this for decades. But recent events are only just now hammering home the real value of this message.

Japanese investors who diversified into bonds - both foreign and domestic - have enjoyed far higher total returns than those who remained fully invested in stocks.

The other major takeaway from Japan's multi-decade bear market is the immense value of global diversification. Take a look at the chart below.

Japan's multi-decade bear market is the immense value of global diversification

In the 1990s, often referred to as Japan's "lost decade," Tokyo's market compounded at just 3% a year for a 35.3% total return. Yet if a Japanese investor diversified into the U.S. market, he would have been well rewarded. During the same period, the U.S. market compounded at 16.7% for a 371% total return.

Global Diversification Worked for Most Japanese Investors

Cynics will point out, of course, that global diversification worked well for the Japanese investor who put money abroad. But what about the hapless U.S. investor who diversified into Japan?

Granted, that investor's returns would have been lower in the 90s. But it's important to note that things have often worked out just the other way around.

  • In the 1970s, for example, the U.S. market returned just 0.34% a year for a 3.4% total return for the decade. Yet the Japanese market compounded at 16%, generating a 10-year return of 344%.

  • Here, the U.S. investor won out. And since it is impossible to know in advance which markets will perform best or for how long, it pays to diversify beyond your own borders.

And here's a tip: Right now the Japanese market is near a 30-year low. Virtually all Japanese companies trade well below their liquidation value.

If you consider yourself a value investor - if you have a contrarian bone in your body - do yourself a favor and put some money to work in either:

  • The iShares MSCI Japan Index (NYSE: EWJ)

  • The Wisdom Tree Japan SmallCap Dividend Fund (NYSE: DFJ)

  • Or both.

It's true that both Japanese and American stocks are extraordinarily cheap from a long-term perspective. But if history demonstrates anything, it's that it pays to hedge your bets.

Good investing,

Alex Green

Today's Investment U Crib Sheet

The Annual Letter to Shareholders, written by Warren Buffett to Berkshire Hathaway's stockholders, stands out as the investing highlight of the year for many. And for good reason. Within the pages of this report is a wealth of investing wisdom, insight and flashes of brilliance from a true master of the investing craft.

Interspersed with technical data on the performance of Berkshire, you can find "Buffett-isms" that help illustrate the state of the company, their thinking, and the economic picture in general. For example...

"As the year progressed, a series of life-threatening problems within many of the world's great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: 'In God we trust; all others pay cash.'"

And within these types of comments you can get a feeling about how Buffett truly wants his businesses to run: efficiently, cost-effectively and growth oriented.

"Similarly, when we purchased PacifiCorp in 2006, we moved aggressively to expand wind generation. Wind capacity was then 33 megawatts. It's now 794, with more coming. (Arriving at PacifiCorp, we found "wind" of a different sort: The company had 98 committees that met frequently. Now there are 28. Meanwhile, we generate and deliver considerably more electricity, doing so with 2% fewer employees.)"

Many of these tongue and cheek statements cut to the heart of what we should be looking for in well-run organizations and ultimately, our investments. Buffett talks briefly about the Great Depression and his view of America's prospects as well.

"Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

"Without fail, however, we've overcome them. In the face of those obstacles - and many others - the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America's best days lie ahead."

If our faith in the greatest country in the world, or the economic system that built it, was in danger of wavering, one hopes that words like these from a true "investing master" would have us immediately looking to the future.

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