What Japan Can Teach You About Investing

Japanese stocks performed better than equities in most other developed countries in the third quarter.

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Japan remains the world’s third largest economy. It’s amazing that it’s still standing. It has the highest GDP to debt ratio of any developed country—almost 300 percent higher than the U.S.

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In May, 2011, the economic news about Japan was extremely grim. Unemployment was up. The Ministry of Health, Labor, and Welfare reported only 61 available jobs for every 100 people seeking employment. The full ramifications of the 9.0 earthquake and tsunami had not been factored in, but they were obviously devastating.

Standard and Poor’s downgraded the debt of the iconic Tokyo Electric Power Company to “junk status.” In January, 2011, Standard & Poor’s cut its rating for Japan’s government debt to AA-, the fourth highest level. This reduced rating placed the government's debt below the ratings of major Japanese companies, like Toyota Motor Co.

Investors in Japanese stocks have required almost legendary patience. The Nikkei 225 (which is the equivalent of our S&P 500 Index) reached an all time high of 38,957 on December 29, 1989. On October 14, 2011, the Nikkei 225 closed at 8,747. Japanese investors have been waiting for a full recovery for more than two decades. It is going to be a long haul.

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Given this dismal news and history, is investing in Japanese stocks prudent? Typically, bad news about government debt ratings, unemployment, natural disasters, and a plummeting stock market would keep all but the hardiest investors from betting on the stocks of that country. The situation in the United States is far less dire, yet the financial media is filled with stories that write off U.S. stocks. How many times have you heard that the U.S. will soon become a second rate economic power and that China, Brazil, and India are the places to invest?

A review of results for the third quarter of 2011 prepared by Dimensional Fund Advisors yields some interesting information. The best performing developed market was—you probably didn’t guess this one—Japan. It was down 6.44 percent. U.S. markets lost 14.17 percent. China was down 26.27 percent. Brazil was down 26.97 percent. India was down 19.94 percent.

For the year to date, a portfolio of 100 percent Treasury bills returned 0.04 percent. At least it was in the black. Globally diversified portfolios with an allocation of 25 percent or more to stocks had losses ranging from 3.28 percent to 13.20 percent. The higher the allocation to stocks, the greater the loss. There are some lessons to be learned from this data:

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Markets are unpredictable. Experts may think stock markets should react in a certain way, but they often don’t. The news from Japan is bad, but its market tops the charts (while still in negative territory). Standard & Poor’s downgraded U.S. debt and money poured into Treasury bonds.

Don’t dump stocks. Periods of uncertainty cause many investors to abandon stocks. But lower stock prices mean higher expected returns. Well-advised investors are in an asset allocation suitable for them and don’t make changes based on short term market volatility. Historically, markets have recovered very rapidly, catching those who fled to safety licking their wounds and failing to regain their losses.

Diversification lowers risk. The key to risk management is not trying to predict random and unpredictable markets. It’s diversifying your risk between stocks and bonds and investing in a globally diversified portfolio of low management fee index funds.

This isn’t advice you are likely to get from your broker or from most advisers. Keep in mind this admonition from Nobel Laureate and famed economist Paul Samuelson: “It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office."

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers, The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

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