From the Archives
Simple Principles of Investment (1919)
Written in 1919, this is probably the world’s most straightforward book on how to invest. While complexity can seem more sophisticated, this author covers the most basic of investment principles, with chapters like:
Couldn’t get much simpler!
Suffice it to say that the last 10 days have been ‘tense’, when it comes to geopolitics. US forces killed Iranian General Qassem Soleimani, which led to the Iranians retaliating by attacking American military bases in Iraq. When the Iranian response took place, the market’s reaction was swift, as investor’s fled to ‘safe haven’ assets. As Bloomberg’s Tracy Alloway pointed out:
Reactions in other asset classes were similar:
After everything that transpired, I began to wonder how markets have reacted to the threat of conflict breaking out, and how they behaved during an actual war. That said, this edition of Financial History: Sunday Reads is dedicated to the topic of war and markets. Hope you enjoy!
Wars, Inflation and Stock Market Returns in France, 1870-1945
This paper offers an interesting argument on the relationship between markets and conflict by positing that the stock market prices are influenced by “the specific way each war is financed.”
“Financed solely by regular long-term debt, the Franco-Prussian war exhibited stock prices that only reflected real activity. On the other hand, both World Wars were partially financed by monetary creation but differed to the extent of financial repression. In the case of World War II, monetary creation within a closed repressed economy led to a paradoxical, short-lived increase in stock prices.”
In addition, the authors analyze how the outbreak of war impacts the ‘characteristics’ of financial markets. For example, the Franco-Prussian war led to a ‘durable high interest rate’, WWI increased volatility while smoothing out public services firms, and WWII ‘affected the components of the stock market’.
In general, though, the three wars left a brutal destruction of market value in their wake, and “the importance of the stock market in the economy decreased” as a result.”
The Effect of War Risk on Managerial and Investor Behavior: Evidence From the Brussels Stock Exchange in the Pre-1914 Era
In this fascinating article by Gertjan Verdickt, he assesses the behavior of both managers and investors when faced with the threat of war.
“With two news-based measures on war, I document that managers mitigated war risk through dividend cuts, arguably to establish a war chest. Moreover, I find that companies postponed their initial public offerings and that foreign companies were more likely to delist after the onset of wars. Investors reacted negatively to the increase in war news coverage. There is evidence of mean-reversion after a threat of war and a negative drift following the start of war. Finally, I highlight the importance of proximity to military conflicts. In general, the evidence indicates that both managers and investors became more risk averse as a consequence of war news.”
For managers, Gertjan demonstrates that:
“Managers mitigated war risk through their dividend policy. When Act increased, I document a contemporaneous decrease in dividend growth – while there is no significant effect when Threat increased. It confirms the importance of dividends as information channel for investors. Only when news was really bad, companies were willing to consider a dividend cut. I also investigate the mechanism behind this effect. I show that the dividend cuts were not the result of a decrease in cash-flows but rather to establish a war chest. The findings suggests that the outbreak of war made firms more risk averse. This conclusion is supported through robustness tests and anecdotal evidence.
Another important decision managers can make is the timing of equity and bond initial public offerings. I find that an increase in Threat and Act leads to a significant decrease in the number of domestic and foreign IPOs. Even when I control for IPO wave, business cycle variation or past stock returns, the evidence suggests that firms postponed their IPOs due to the increase in war news coverage. This points to manager becoming more risk averse. Moreover, I show that foreign companies were more likely to delist from the BSE after an increase in Act – while there is no effect for Threat. Since stock delistings were costly, and most often an irredeemable decision, it is intuitive that companies delayed such a decision only when news was really bad. Therefore, the evidence shows that war risk was an important factor in managerial decisions.”
“Second, I document investors changed their expectations as a consequence of war risk. An increase in Threat and Act has a contemporaneous decrease in stock prices. In the case of Threat, the results point to an increase in expected returns. Since there is only one lag of Threat significant, this indicates that the effect is temporary (i.e. mean-reversion). When Act increases, the magnitude of the impact is larger. There are two explanations. First, investors became more risk averse. They changed expectations on future returns and current dividend growth rates, simultaneously. Second, the outbreak of wars is associated with larger uncertainty and welfare costs. I show that Act has a permanent negative impact on stock prices (i.e. negative drift). Hence, I conclude that investors wanted to be compensated for the additional risks, and thus increased their expected returns.
There is evidence of the importance of proximity to war. Increases in the metrics lead to a contemporaneous decrease in stock prices for European countries, not captured by the measures. For other countries, however, there is no significant change in stock prices, following an increase in the level of Threat and Act. This suggests that investors assess the likelihood of spill-over to other countries. Investors would only sell stocks when they consider the possibility of a war to be high. This highlights that war risk was an important source of systematic risk, but it was local rather than global. I fail to find evidence to that colonial stocks are affected by events in their controlling countries, also referred to as the empire effect (Ferguson and Schularick 2006). In turn, this highlights potential diversification opportunities for investors. Since the industries are not driving the results, investors should diversify their portfolio on the country rather than sector level.”
The Century of War: Bear Markets in the 1700s
The 18th century was filled with military conflicts, and according to Global Financial Data: bear markets. This article breaks down the five bear markets of the century, with many of them related to some sort of conflict. The paper concludes:
“In many ways, the 1800s were the opposite of the 1700s. The century from 1815 until 1914 was a period of peace. The only major war during that time was the American Civil War. Wars in Europe, such as the Franco-Prussian War were short. One wonders whether the Industrial Revolution would have occurred in the 1700s if Europe had avoided the wars that occurred between 1688 and 1815. The peace between 1815 and 1914 allowed Europe to invest in railroads and other industries that created the modern world. While there were six bear markets between 1688 and 1799, there were only four bear markets in the world between 1800 and 1914. The thirty years of war between 1914 and 1950 led to four more bear markets. War is the enemy of all investors.”
The Effect of World War Two on the British Stock Market
This week’s articles would not be complete without one specifically covering Britain in World War Two.
“This paper studies the effect of World War Two (WWII) on the British stock market. It contributes to the literature in several ways. First, this paper thoroughly investigates the impact of historically major events on the British stock market using a variety of empirical approaches in order to ensure a comprehensive examination of the impact of WWII on British stock returns. We utilize an event study of pre-selected historically major events, an investigation of the possible causes of the largest price movements as well as utilizing an endogenous procedure testing for structural breaks. Secondly we extend the literature on behavioral finance and investor sentiment in extreme circumstances. In particular we examine the ‘negativity effect’, documented by Akhtar et al (2011) and determine whether stock returns reacted more strongly to negative events or positive events. Overall we find limited evidence of strong links between war events and market returns although there is support for the ‘negativity effect’.”
Earning from History? Financial Markets and the Approach of World Wars
In this incredibly detailed piece, Niall Ferguson addresses a key question:
“Are world financial markets paying due heed to geopolitical risk?”
The renowned historian continues to state:
“Despite unchallenged U.S. military supremacy, the financial consequences of a terrorist nuclear strike, or war in the Middle East or the Taiwan Strait—or some totally unforeseen conflict—could still be enormous. That globalization under a powerful hegemon has strengthened linkages among national economies may not rule out another major war: such linkages were also strong on the eve of World War I, which thus caught investors off guard. Investors try to learn from history, but the very different financial impacts of the two world wars and the Cold War reveal the tendency of military technology and regulatory regimes to shift significantly, reducing the relevance of past experience. Any lessons investors might take from the last war could have limited relevance for the next—or be forgotten after a generation of relative peace has led to complacency.”
Using over a century of evidence, Ferguson argues that investors cannot confidently rely upon previous wars to guide their assessment of current conflicts.
“The financial history of twentieth-century world wars seems to suggest that it is as unwise for investors as for generals to try to fight the last war rather than the next one. Investors failed to anticipate the huge liquidity crisis unleashed by the First World War. They largely failed to protect themselves against the longer-term effects of a big war on continental securities and currencies. Yet knowing in the 1930s what had happened to various asset classes after 1914 did not provide a ready-made strategy for weathering the next world war. Changes in military technology and government regulation ensured that one could never be certain that the next war would have the same financial impact as the previous war.”
The author concludes with three final lessons of history that investors should note:
“One important lesson of history is that major wars can arise even when economic globalization is very far advanced and the hegemonic position of an English-speaking empire seems fairly secure. The second important lesson is that the longer the world goes without a major war, the harder one becomes to imagine (and, perhaps, the easier one becomes to start). The third and final lesson is that when a crisis strikes complacent investors, it causes much more disruption than when it strikes battle-scarred ones. Interminable overtures may be dispiriting. For financial markets, however, bolts from the blue are worse.”
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