Friday, April 3, 2015

American (financial) exceptionalism

It is said that history is written by the winners. For investors who study financial history, they shouldn't fall into the same trap of getting blinded by the story of winners.

Here is an example, a recent Bloomberg column by Barry Ritholz concluded that investors shouldn't get overly concerned by the prospect of war:
That may seem counterintuitive, but if you delve into history, you will discover that markets have more or less found the normal turmoil of geopolitics to be irrelevant. The reasons for this are varied, but consider these factors:

1) Most geopolitical events don't affect corporate revenue and earnings. Even trade restrictions tend to cause consumption to shift as opposed to going way (though there are, of course, some exceptions).

2) Despite the big bold headlines, most of these events are relatively small from a global economic perspective. Take the Russian-Ukraine skirmishes. Ukraine’s annual gross domestic product is equal to about two days of U.S. GDP.

3) Markets tend to anticipate large events; by the time news breaks, many key investors have already made adjustments to their holdings. “Buy the rumor, sell the news,” is another way of saying the news is already reflected in stock prices.

Hence, “Lose the News” is often good advice for longer-term investors.
Barry is correct in his analysis, up to a point. But he makes to mistake of interpreting history from the viewpoint of the winner. From the perspective of an American investor, his analysis holds up well for the last century. To say that wars, or by extension, geopolitics doesn't matter is to fall into the trap of American (financial) exceptionalism. Even the CFA Institute recently published a paper on how geopolitics affect investments. In addition, Barry`s analysis has severe survivorship problems, as I pointed out before (see The One Big Bet made by most buy-and-hold portfolios), .

Survivorship bias in the data
Recall that 100 years ago, the global major powers were Britain, France, Germany, Austria-Hungary (remember them?) and Russia. Other smaller powers included Italy, Turkey, Japan, the US, Argentina and Canada, just to name a few. As per data from Credit Suisse, here are the real returns of German stock bond and cash assets since 1900. $1 invested in German equities in 1900 would have netted you $38 on an inflation adjusted basis in 2013 (and there was *ahem* severe volatility in the 1914-18 and 1939-45 period). How would those assumptions work in your rate of return models?

Here is the chart for Japan:

Russian investors did far worse, assuming that they were allowed to live;

The same could be said of Chinese investors:

Now do you understand what I mean by (financial) history being told by the winners and American exceptionalism? Here are the asset returns of some of the winning countries of the First and Second World War. Take, for example, France, whose real equity returns wasn't that different than German ones, though the downside volatility was not as severe:

UK returns did reasonably well, as Britain never had unfriendly foreign troops on its soil:

By contrast, here are the US returns. Notwithstanding the problems faced by losing countries like Japan and Germany, An American equity investor who started with $1 in equities in 1900 ended up with a whopping real $1,248 in 2013, compared to $379 for a British investor, the resident of another winning country.

Survivorship bias and American exceptionalism indeed! The story of finance has mainly been told from the perspective of one of the most successful winners of the past century. The question then becomes, "Is the American perspective the correct one for financial planning?"

Another American perspective
If you don't believe me and still think that America is different from the rest of the world, let's go back a little further in America's past, beyond the 1900 start date of the Credit Suisse study. This tweet from Plan Maestro shows the price performance of Confederate bonds during the 19th Century.

How did the holders of those bonds fare, assuming that they survived the burning of Atlanta in Sherman's march to the sea? Did southerners name their sons Ozymandias?
I met a traveller from an antique land
Who said: "Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shattered visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them and the heart that fed.
And on the pedestal these words appear:
`My name is Ozymandias, King of Kings:
Look on my works, ye mighty, and despair!'
Nothing beside remains. Round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away".
Ask yourself realistically, "How would war affect my portfolio if I were in the shoes of any of those unfortunate souls who happened to be on the losing side?"


Otto said...

Interesting, but ultimately a variant of the "sh_tload of nuclear weapons" foreign policy, which states that any war that USA loses from now on will either be of the non-catastrophic guerrilla variety, or the really catastrophic type. In the case of the latter coming to pass, stock markets would be the least of our worries.

Cam Hui, CFA said...


Don't forget that Britain never saw unfriendly foreign troops on its soil in the last 100 years, but real equity returns were quite disappointing compared to the US.

SGrey said...

"USA loses from now on will either be of the non-catastrophic guerrilla variety, or the really catastrophic type" doesn't that statement assume the state, act and method of war to be a static thing? Nascent cyber & biological battlefields & battles are only two examples of where winners/and loser will/may be decided in future conflict. War, like any communal human activity, is fluid and creates new expressions of itself, thereby creating new winners and losers. Put more simply, there's never been a winner that remained a winner forever, and the their reasons for loosing were always unforeseen.

Perry R. said...

Barry Ritholtz’s blog posted the article “War Makes Us Poor” (Apr. 30, 2014) indicating he is (or at least was) aware of the negative impact of war:

In the recent article you cited he does seem to contradict this with statements like “After the attack on Pearl Harbor, the U.S. entry into the war did nothing to slow market gains. “ However, I agree in the sense that attempting to trade based on news of local wars is likely to be fruitless as you would need to be a superb forecaster and also take a large (risky) position to positively influence the direction of your balanced portfolio. Over-reaction and panic selling due to geopolitical turmoil news is far more likely than trading successfully.

I’m curious how you would propose preparing for the impact of a major, empire destroying war? I can only imagine two useful responses:

1) invest globally with minimal home country bias.
2) be prepared to move self and assets to a safer country if your government slides toward the abyss of adopting policies that promote world war or undermining property rights. Good luck making that call.