Misleading Indicators
BENJAMIN GRAHAM, the father of investment analysis, made this observation: “The investor’s chief problem—even his worst enemy—is likely to be himself.”
Why? One reason is our intuition can sometimes lead us astray. Things that seem like they make sense, and seem like they ought to be true, often turn out not to be supported by the data.
Perhaps the best-known example is the divergence between growth and value stocks. Intuition suggests that growth stocks—companies like Apple and Amazon—would deliver better performance than their more pedestrian peers on the value side of the market. But it turns out that value stocks, including banks, insurers and industrial companies, have delivered better returns, on average, than their more popular peers. This isn’t the case in every time period, but it’s been true over the long term.
An analogous dynamic applies at the country level. Regions that are growing quickly, as measured by GDP growth, seem like they ought to be good investments. But according to the data, the opposite is true. This has been known for some time, but was recently confirmed in a new study by Derek Horstmeyer, a finance professor at George Mason University.
Horstmeyer looked at 34 markets from around the world and examined the relationship between investment returns and GDP growth. What he found was that the relationship was nearly inverse: “Out of the top seven fastest-growing countries over the past 10 years, only one had a positive annual rate of return in the stock market.”
China, the fastest growing country in the group, with 6.8% average annual GDP growth, saw its stock market fall by about 0.1% a year. Other emerging-markets countries delivered similarly poor returns. Malaysia, Indonesia and the Philippines—all with GDP growth rates more than double that of the U.S.—had negative stock market returns over 10 years.
Meanwhile, some of the slowest-growing countries in the world delivered very reasonable, positive returns. This includes Italy, France, Germany and Japan—countries where GDP has grown at an anemic rate of under 2% a year, and even under 1% in some cases.
Overall, the fastest growing quartile of countries delivered average stock market returns of just 0.1% over the past 10 years, while the slowest-growing quartile delivered market returns of 3.4% a year—entirely contrary to intuition.
As an individual investor, what can we learn from these results? I see five lessons.
1. Exchange rates. A key feature of this study is that the investment returns were measured in dollar terms. This was intentional, to simulate the real-world results that a U.S.-based investor would have received. These market returns, however, differed—sometimes significantly—from the returns that an investor would have received in each country’s local currency.
Because of currency fluctuations, in other words, a given country’s stock market might deliver positive returns in that country’s currency but negative returns after being converted to dollars. This is one of the key risks when investing in international stocks. Of course, currency shifts can go in the other direction and benefit investors. But this is hard to predict. It’s because of this added element of uncertainty that I suggest limiting exposure to international stocks.
2. Stories. In the past, I’ve referenced the book Narrative Economics by Robert Shiller. Stories often drive markets. That’s because stories are entertaining, they’re easy to remember and they often sound like they make sense. But they can also be completely wrong. Thus, in making financial decisions, it’s important to rely more on data than intuition—and to be especially wary of storytellers.
3. Data. Even when the data seem clear, things may not turn out as expected. Consider this seemingly clear fact pattern: Today, the U.S. market is trading at 22 times expected earnings, while emerging-markets countries are trading at just 12. Combine that with faster population growth and rapid industrialization, and it seems like emerging markets should be delivering above-average market returns.
But they haven’t. Why? Data, even when it’s reliable, can’t predict the future. There are simply too many variables at play.
4. Institutions. A few weeks back, I discussed the work of this year’s Nobel Prize winners in economics. Their key finding: Political and economic institutions are the most important drivers of countries’ economic success. Even countries that are doing well are apt to stumble if their governments are too autocratic.
This has been the case most notably in China, where—despite strong economic growth—the regime’s heavy-handed policies have damaged investment returns. The lesson: When investing in international markets, be sure to assess whether a given government is playing by the rules we know and expect—or whether it’s playing by its own rules.
5. Diversification. While diversification might be the first rule in investing, there’s no rule dictating how diversification must be achieved. In building a stock portfolio, one school of thought is to mirror the global economy—an approach Jonathan advocated in his article yesterday. But if U.S. stocks account for 65% or so of global stock market value, should U.S. stocks really be just 65% of an investor’s stock portfolio? Yes, that’s one way to diversify, but it’s not the only way.
Indeed, Jack Bogle, founder of the Vanguard Group, saw no need to invest outside the U.S. With more than 4,000 public companies in the U.S., there’s a reasonable argument that this alone provides sufficient diversification. Meanwhile, others—myself included—believe there’s a benefit to having some international exposure, but only a modest amount. What’s most important to recognize is that no amount of math will yield the optimal answer. A balanced judgment is likely to provide as good an answer as any.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.The post Misleading Indicators appeared first on HumbleDollar.
