Monday, July 14, 2014

My family history as a lesson in long-term return expectations

Occasionally, I come across charts like these of long-term asset returns - and they drive me crazy because of the lapses made in the underlying assumptions.

I`ve written about this before and the problem is survivorship bias (see What actually happens in the long run). This chart of equity returns likely referred to US equities, but that`s really a form of cherry picking the successful markets.

Consider that a little over 100 years ago, the Archduke Ferdinand, heir to the Austro-Hungarian throne, was assassinated in Sarajevo and that event sparked the First World War Great War. At that time, the major powers and markets of the world were: Britain, France, Germany, Austria-Hungary and Russia. Smaller developed powers included Italy and the Ottoman Empire, or Turkey. How would you have performed if you had bought into a diversified portfolio of these "developed markets" and held your positions over the last 100 years? Would the results have in any way resembled the chart above?

What about emerging markets? At the time, the major EM markets consisted of the US, Canada, Argentina and Japan. What would have that kind of diversification bought you?

Risk of war and confiscation
What people seem to forget is one long-term risk of investment is the risk of the permanent loss of capital from war and confiscation. The story of my own family is a vivid illustration of that point.

My father`s family is ethnic Chinese from Vietnam. My great-grandfather, the Old Man, made his fortune when he went to Vietnam as a penniless immigrant from China. Over time, the family became one of the more prominent Chinese families in Vietnam and owned about one-quarter of the property in Saigon Ho Chi Minh City. Indeed, a visitor to HCM City today can visit the old family compound and still see the family crest on the gates around the compound, which occupied a city block and is roughly the size and equivalent location of Rockefeller Plaza in Manhattan. In the our heyday, the family name would have been as recognizable as a Rockefeller or duPont.

Not that I am complaining, but I hardly had an upbringing that was equivalent to one of the Rich Kids of Instagram. That`s because the vast majority of family wealth vanished because we fell victim to the risk of war and confiscation.

Imagine a diversified portfolio...
Going back 100 years, consider how a diversified balanced portfolio of stocks and bonds invested in then blue-chip "developed markets" might have performed, either on a capitalization or equal-weighted basis. The only one that survived relatively intact was the UK. The others, France, Germany, Austria-Hungary (yes, remember them?), Russia suffered tremendous hardship, *ahem* involuntary changes in governments and capital destruction.

So whenever someone shows me a chart of long-term equity returns and tries to use those figures as their assumption to calculate either equity return assumptions or the equity risk premium, I shake my head.

The moral of this story is: When you build models, you have to think hard about your assumptions. Don`t get blinded by either cultural or survivorship biases.

1 comment:

Dan Phan said...

I read your post with much interest, for having had keen interest in what happened to South Vietnam economically in the years following the communist take over in 1975. With their "danh tu san mai ban" policy whereby all private production means were confiscated and the three attempts at old to new currency conversions (each time, only a limited amount of cash can be kept), the communist regime had successfully and completely dismantled the entire economic engine of South Vietnam by about 1979. The Vietnamese was, and still is, a people too proud to recognize that it is the entrepreneurial Chinese minority, through their industriousness and vast connections, that drives the economic power in that part of the world, just like in Singapore, Malaysia, The Philippines, even Thailand. There is little doubt that Vietnam would have been in much better economic power today had the communists just stopped at declararing their (arguably false) victory in 1975.

One way to assure this kind of systemic wealth destruction does not happen again, or at least mitigate its chance of occuring again, is to accompany one's wealth with power, political or otherwise. What happened to the Jews in the 1930s can also serve as a proof point.