Thursday, May 15, 2008

Don't get caught in a bubble - Part 1

Investing in stocks or real estate or any other asset class is a good thing most of the time. Over time, most "well-known" investable asset classes give a good real rate of return (ie a return that can beat inflation lah). Ok the other caveat here is "well-known" asset classes, ie dont go and invest in wine or art, jewellery etc, chances are you are likely not to see your money again.

Just some ballpark no.s to play with, historically these asset classes have been able to generate these returns (nominal not real and they also include dividend or other forms of yield, real return will be these no.s - inflation rate)

Stocks 10%pa
Real Estate 12%pa
Private Equity 15%pa
Bonds 5%pa
Commodities 8%pa

However, as we all know, these are historical AVERAGE returns, There is no guarantee that the future will be like the past. It may not be possible for us to enjoy these returns going into the future. In fact if you had invested at the wrong time, there is a chance that you will never get close to these rate of returns.

Of course the wrong time willl be ********drumrolls******** investing at the peak of some bubble. I shall highlight three real life examples on how investing at the peak of some bubble will make sure that you will earn a meagre return over a long period of time.

The first bubble that we are going to introduce here is probably the biggest bubble in recent history (yes even bigger than the dot com bubble) in terms of magnitude. There are two asset classes involved: real estate and stock market (as usual btw) and sadly these asset classes never ever recover close to its peak even after 19 long years.

Yes this is the Japanese bubble which ended in 1990 when everything collapsed. At the peak of the bubble, the Nikkei was close to 40,000 and real estate prices in Tokyo reached close to USD 140,000 psf. (Okay so Singapore is not so bad lah, only SGD 3,000+ psf this time round, we are about 2 more digits away).

Today the Nikkei stock index hovers around 13,000 levels and Tokyo real estate prices are on par with Singapore's SGD 3,000+ psf. A lot of Japanese that invested in real estate near the peak had to finance their mortgage with maturities stretching 2 lifetimes ie the sons have to continue to pay the father's mortgage.

Imagine if you have bought stocks or real estate even at 30% below its peak level, you will still not see your capital today, and the sad truth is, perhaps you will never ever see your capital again.

As for the stock market, the Nikkei declined steadily over the next 13 yrs after it cracked in 1990 and eventually reached a bottom at around 8,000 in 2003. So even if you DCA all the way down, you may not have broken even today. Subsequently, it rebounded to 18,000 before declining back to 13,000 today.

Moral of the story: Don't get caught in a bubble, but easier said than done right?

To be continued...


  1. Hi 8percent,

    Out of curiosity, where did you get the historical returns on the various types of investment?

    Secondly, since PE normally invest in business, i.e., the stock market, how then is it possible that PE returns more than the equity market? Moreover, PE takes a cut out of the share before returning to the investors.

    Over the long run, how is it possible that Real Estate returns 12% (whether nominal or real) on an annual basis?

    And also commodities, returning 8% over the long run annually?

    If that is the case, especially for commodities, majority of the population will die of hunger because majority of the population do not have an inkling or even the knowledge to beat inflation. And 8% over the long run is definitely a figure over and above any long-term inflation rate.


  2. Hi BC

    Very sharp observation. I must confess I do not have strong evidence to prove that these no.s are the whole truth. But they should not be too far off the mark. I pluck these no.s from my vague memory bank after seeing them a couple of time during courses/reading etc. So naturally, some no.s should be off.

    The original thought basis that stuck with me was of course high risk, high return based on portfolio theory so if you look at all the asset classes, I would say that risk as measured by standard deviation should be in ranked fr small to large in the following manner

    1) Bonds, 2) Equities, 3) Commodities, 4) RE, 5) private equity
    Admittedly 2,3 or 3,4 can be trickly but roughly the trend is there.
    So naturally rate of returns should follow in a similar order

    There are some textbooks/websites that will show very good documented historical rates of return for asset classes, but what I could find using google are these

    according to the site above PE is 15% and RE is 10%

    according to the site above commodities 11%

    So, I guess my no.s are not too far off :)
    The no.s that are a bit off are for commodities 8% vs 11%, but by and large I think the rough picture is there.

    "Commodities run double digit return yet the general public didnt go bankrupt?" is a question that I think begs a question itself and runs into the realm of philosophy. Maybe more and more of the poor in the world are indeed dying of hunger? Maybe selected groups of people are really benefitting esp during the oil shock of 1970s and today? It is a question not so easy to answer...

    But the other angle to answer the question directly would be layers of cost absorption that shield the consumer from the full brunt of some commodity price increase. Eg less copper can be used to wire the whole building today vs 20 yrs ago. Or cost absorption by distributors/govts/retailers for soft commodities (rice, coffee etc).

    I think the intent of your questions would actually be how can these alternative asset classes like RE, commodities and PE actually earn signficantly more than public stocks?

    My answer would be as mentioned above. Higher risk assets should generate higher returns and I think it is safe to assume that all these asset classes (RE, commodities and PE) are much riskier than stocks and bonds since they are not scruntinized by the public, have much less liquidity, huge information disparity etc. So naturally they should command a higher return. If not, then who would invest in them?

    Arguing from another perspective, since these asset classes (RE, commodities and PE) are much riskier than stocks and bonds since they are not scruntinized by the public, have much less liquidity, huge information disparity, maybe the rates of return are not the whole truth bcos of cover-ups, survivorship bias, data mining etc. But that's another topic I guess.

    So that's my two cents.
    Hope this helps.

  3. I cannot believe that something like this can happen in the united states of america. We now live in a nation where the type of type of financial shenanigans occuring on a daily basis would only be thought of as happening in third world countries maybe south america. But now their happening here. I don"t believe that we are seeing so much of a big increase in the financial shenanigans today but less enforcment of violations of securities laws by the SEC. I can remember back in the nineteen eighities when almost two thirds of all the savings and loans were taken over by the FDIC the arm of the federal government that is suppose to regulate banks and other financial institutions. Their were thousands of persons charged with all sorts of crimes during and after the savings and loan debacle. I cannot believe that not anyone on wall street has been charged with any sort of crime whatsoever after the financial crisis of two thousand eight and two thousand nine that almost brought down the whole financial system.