When I was in high school, Japan Inc. seemed invincible. Their economy was booming, which pushed up their real estate and stock markets, and a handful of over-the-top events like the purchase of Rockefeller Plaza by Japanese investors and the sale of Van Gogh’s Portrait of Doctor Cachet sold for $82.5 million (or $189.5 million in today’s dollars).

From 1970-1989, the Japanese stock market, according to MSCI, gained 16.9 percent per year, for a cumulative gain of 2,177 percent. At the same time, the S&P 500 gained 10.4 percent per year, which resulted in a cumulative increase of 690 percent.

Of course, we all know what happened next: the bubble burst, and Japan Inc. went from a miracle to moribund. Japanese stocks fell by -70 percent and didn’t reach the 1989 high until 2021. That’s right – a 32-year drawdown.

Although evident in hindsight, the stock market valuation was absurd, with a Shiller PE ratio of almost 100. For reference, the Shiller PE ratio ‘only’ reached 40 in our late 1990s tech bubble.

The post-1989 experience for Japanese investors is pretty terrible, with returns of less than one percent for the past 33.5 years. The cumulative return is about 31.8 percent, which compares to a cumulative return of 2,453 percent for the S&P 500 over the same time frame.

It does appear that Japanese stocks have found their footing, up 9.3 percent annually in the last decade. That’s below US stocks, but US stocks have been the best-performing major market in the world since the 2007 global financial crisis.

What lessons can we draw from the Japanese market experience?

• Bubbles exist. Pure market efficient markets people argue that bubbles don’t exist, and while it’s true that they are hard to see in real-time, there’s no question that they are real. There is no justification for a 100x valuation for an entire market (one stock is hard enough to justify).
• Global diversification matters. After 15 years of US stock market dominance, it’s easy to want to skip foreign stocks altogether. With the benefit of perfect hindsight, the optimal portfolio from a risk-adjusted return standpoint is 84 percent US stocks and 16 percent Japanese stocks.
• Even if the optimal risk-adjusted return portfolio doesn’t resonate with you, think about global diversification from the standpoint of the Japanese investor. A Japanese investor who didn’t include some US stocks slogged through a challenging 20-year period that could have been avoided with some global diversification.
• Trees don’t grow to the sky. I like to think of the Shiller PE ratio inversely, as an earnings yield. At a 100 Shiller PE, that implies that the real expected return on Japanese stocks was one percent (1/100). That’s pretty paltry and pretty close to the subsequent realized return. High valuations feel good because they result from solid returns, but they often just pull returns from the future.
• Don’t forget to rebalance. A Japanese investor who enjoyed those massive returns and rebalanced out of Japanese stocks as they rose into other stock markets or bonds fared much better than the investor who didn’t when the party ended.
• Risk Management matters. Putting all your eggs in one basket isn’t a good idea, even when it seems like that basket can do no wrong. An investor that diversified was a lot happier in the long run.
• The long run can take a lot longer than you think. I remember when we had ten years of no returns for US stocks, and everyone called it the ‘lost decade.’ In Japan, it was more like a lost generation or two.

Hopefully, US investors will never endure what Japanese investors did for such a long time. We had the Great Depression, and while I think that’s unlikely to happen again, the Japanese market experience is a good reminder that markets can be challenging for a long time, even without an economic depression.

For me, the Japanese experience drives home why we do what we do: diversify to assets other than stocks and diversify within stocks to include different countries. And don’t buy a painting for $82.5 million, even when it is fantastically beautiful.