Andrew Hallam
28.10.21

When Speculation Crashes
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Will Ferguson doesn’t remember saying it. The Canadian English teacher was living in Japan and drunk at an after-work party. But his colleagues remembered what he said, and several weeks later, they continued to bring it up.

In Japan, the cherry blossoms bloom first in the south, and they remain so for about a week. If someone began a journey on Japan’s southern tip and traveled to the country’s northern point, they could bask in the pink flowered bloom, known as Sakura, for longer than a month. Ferguson, in his inebriated state, claimed he would do just that.

In his book, Hitching Rides with Buddha, Ferguson describes why he decided to eventually take the trip. If he hitchhiked the entire way, he might find what he called, “the true heart of Japan.” It might help him answer questions such as, “What makes these people tick?”

Culturally, we’re all unique. But our motivations, even if they look different, remain the same no matter what: we want to survive; we want to live the best lives we can; we want to protect those we love.

Even Kamikaze pilots during World War II didn’t differ much. Ferguson describes their last radioed words before their explosive-laden aircraft slammed into opposing ships. They didn’t scream, “Long live the emperor!” Instead, they cried for their mamas. They were human, after all.

We often rationalize our actions, finding support for decisions we make. Such is the case when an asset class rises faster than the law of economics says it should. We invest in things that are rising in value because we hope they’ll rise further. And such hopes become beliefs once we’ve already committed money. This is known as the endowment effect: when something is worth even more in the eyes of an owner who just acquired it.

But economic laws are like rubber bands. They stretch–sometimes really far– before they snap. Such was the case with Japanese stocks. They became the world’s hottest tickets. After World War II, Japanese businesses began to thrive, and the prices of those stocks rose in line with business earnings…until they didn’t. The elastic began to stretch.

From 1950-1960, the Nikkei 225 index of Japanese stocks (measured in USD) averaged 37.64 percent per year, including reinvested dividends. That was a 10-year gain of 2,340 percent. But Japanese businesses didn’t increase their earnings by 2,340 percent, so the elastic grew thinner.

Over the next 20 years, the band stretched further as Japanese stock prices continued to rise far faster than business earnings. Including reinvested dividends, Japanese stocks averaged a compound annual return of 15.86 percent from 1960-1980. In other words, over that twenty-year period, they gained a total of 1,800 percent. Once again, business earnings didn’t average growth even close to 15.86 percent per year.

Let’s put this in perspective. If somebody could have invested $1000 in a US stock index between 1950 and 1980, that money would have grown to $24,032. That’s a great return. But if $1000 were invested in a Japanese stock index over the same time period, it would have grown to $462,739. That’s another world.

The PE ratio for the average Japanese stock traded above 70 times earnings in 1989. The Japanese stock market was the largest on the planet. Hope, greed and belief continued to pull on the elastic band. The endowment effect grew stronger as experts rationalized prices.

Over the 40 years between 1950 and 1990, Japanese stocks averaged 21.88 percent per year, including reinvested dividends. That means a $1000 investment in Japanese stocks would have grown to $2,737,145. Yep, a thousand bucks would have ballooned to more than $2.7 million.

Those returns attracted more investors. By the late 1980s, Japanese stocks were hotter than Bitcoin. But the fundamentals to support those prices simply weren’t there. That’s why the elastic snapped. Those who suffered most were retail investors who jumped on late, often after seeing their friends make easy money.

But in 1989, Japanese stocks crashed. If someone lumped $1000 in Japanese stocks at the beginning of the year, it would have been worth just $360 three years later. Between January 1989 and September 30, 2021, Japanese stocks gained a compound annual return of just 1.76 percent, including reinvested dividends.

As humans, we culturally differ. But we’re all still the same. We want to live well. But that can push us to be greedy. We chase rising asset classes. We often ignore fundamentals. We say, “This time, it’s different.”

Whether we’re talking about an individual stock, a country’s stock market, real estate prices, Dutch tulip bulbs or a crypto-currency, the fundamental laws of economics always, eventually, have the final say. That’s why, if you’re putting your money into something that doesn’t earn business or rental earnings that’s not an investment, it’s a speculation.

Cherry Blossoms don’t last forever. Nor do soaring prices that rise faster than fundamentals. So if you want to invest well, don’t speculate. Build a globally diversified portfolio of stock and bond market index funds. Add money when you have it. Rebalance as needed back to your goal allocation. That’s easier said than done. You’ll always be tempted to chase seemingly easy money. But when the plane goes down, you won’t be screaming out, “Long Live Speculation!”

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

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