The World is Flat (Sometimes)

Some of my favorite subjects in grade school were the accounts of famous global explorers such as Magellan and Columbus. The history of these pioneers usually has some attachment to the flat Earth theory–what was thought to be the prevailing thought during the middle ages. As it turns out this sentiment at the time was largely false as the ancient Greeks were among the first to theorize that the Earth was indeed spherical.

Fast-forward to the modern day. We now live in a world where indexing is quickly becoming the pre-eminent method of investing for individuals (a good thing in my opinion). The innovation and technology available to fund providers, coupled with a demand for low cost, diversified, and transparent funds has provided modern day retail investors with a tremendous set of tools that were largely unavailable only decades ago. Foreign markets that were once difficult to access are now easily available with the click of a mouse. But global equity markets have their own horizontal tendencies.

As an example, consider US stocks during the first decade of the twenty-first century. Despite a substantial amount of volatility US stocks, as measured by the S&P 500, provided investors with an annualized total return of 0.4%. That’s it! And this phenomenon was not an isolated event. The US had previously experienced prolonged “flat” markets during recovery from the great depression as well as an eight year period spanning the late 60s and early 70s.

Annualized US Stock Performance
(S&P 500 Total Return)
Period CAGR Volatility
Jan 1931 – Jun 1942 0.4% 35.6%
Oct 1966 – Sep 1974 -0.2% 14.4%
Jan 2000 – Dec 2009 0.4% 16.4%
Source: SBBI

Notice these periods were still fairly volatile despite the fact that little, if any, returns were generated. Modern portfolio theory makes the claim that returns are a reward for bearing risk (as measured by volatility), but this relationship doesn’t necessarily hold all the time. Equities can be incredibly volatile while providing little in the way of return. As Howard Marks put it so eloquently, risky assets carry with them the expectation of high returns, but there’s no guarantee that those high rates of return will materialize.

The United States was not the only country to suffer prolonged low rates of return. The phenomenon has in fact occurred in many developed nations and over different periods of time. Here’s a brief sample:

Annualized Global Stock Performance
(MSCI Country Indexes Total Return)
Country Period CAGR Volatility
Japan Jan 1989 – Sep 2016 -0.05% 20.6%
United Kingdom Jan 1970 – Dec 1976 0.2% 35.2%
France Mar 2007 – Sep 2016 0.5% 23.3%
Germany Jun 1998 – Nov 2008 0.1% 24.4%
Austria Aug 1973 – Feb 1985 -0.3% 13.9%
Oct 1990 – Dec 2002 -0.4% 23.5%
Singapore Jan 1994 – Sep 2004 -0.05% 27.6%
Hong Kong Nov 1993 – Dec 2002 -0.1% 31.3%
Source: MSCI

Attempting to understand why these various markets have behaved in such a manner is difficult. Austria appeared to be completely unaffected by the dot-com boom of the late 1990s, and the Japanese market since the late 1980s has somewhat of a sine-wave like shape. Overall it’s a mixed bag of behavior. What’s important to realize is that it has happened before, it could happen again, and no country or region is immune. Keep in mind the international data from MSCI goes back only 47 years. The picture gets much uglier when two world wars and a global depression of the early twentieth century are considered.

Source: MSCI

The above data make the argument that there’s plenty of risk associated with simply holding an index that goes beyond volatility or drawdown. It’s enough to make one question the prospects of a simple buy-and-hold investment policy. Historically such an approach has worked wonderful over long stretches of time (30 years or longer). But those long stretches of time can certainly hide some undesirable performance.

While such behavior is largely out of our control our decisions on how to allocate or invest are within our circle of influence. Without any way of knowing which country or region will out-perform or under-perform, having exposure to a broad range of countries and regions is without a doubt the safest bet to make. All of this makes it incredibly difficult to agree with either Buffett or Bogle on their US equities only investment strategy. [1,2]

There’s a few things that can help improve the situation. Having a least a small amount of active management can do wonders. This need not be anything more than regularly rebalancing among a diversified portfolio of global equities. It’s also important to remember that volatility is an investors friend as it provides the opportunity to rebalance.

Diversification isn’t just about reducing volatility. It’s also about providing options. In a world where anything can and will happen diversification helps improve the chances of investment success by spreading bets across a wide range of potential winners. That being said I’m a huge fan of global diversification, lest my investments sail off the edge.

Source: MSCI

1. Buffett, Warren. 2013 Berkshire Hathaway Shareholder Letter. p.20.
2. Fried, Carla. Jack Bogle: I Wouldn’t Risk Investing Outside the U.S. September 12, 2014.

What I’m Reading
Lessons from Betting on a Biased Coin: Cool heads and cautionary tales (Elm Fund)
podcast: Masters in Business: Aswath Damodaran (Barry Ritholtz)
Most Of What You Probably Think About Investing Is Wrong (Lawrence Hamtil)
ETFs May Actually Make Weak Players Weaker (Econompic)
How Investors Develop Bad Habits (Ben Carlson)