BONUS: Stocks, Bonds, and War

Episode Summary

Executive Summary: The episode uses historical market data to contextualize the Ukraine war, arguing that wars raise volatility and can hurt returns, but they are poor tools for market timing. The hosts emphasize diversification, long-term discipline, and pre-crisis risk management, noting that the biggest market drawdowns often happened in peacetime, not war, and that global markets have remained resilient across many crises.

Main Topics: War, markets, and why the episode exists (Priority: 5/5): The hosts frame the episode as a non-political, data-driven response to listener anxiety about Ukraine, emphasizing humanitarian tragedy first and financial market implications second. Historical market impact of major wars (Priority: 5/5): They review World War I and II examples showing severe losses in some countries, but mixed outcomes globally, with some markets recovering strongly and others suffering near-total destruction. Political crises, volatility, and average returns (Priority: 5/5): A broader paper on international crises is used to show crises are frequent, lower global returns on average, and increase volatility, but the effects are uneven and not predictive enough for timing. Bonds are not always safe in real terms (Priority: 4/5): The transcript highlights long periods when government bonds delivered negative real returns, especially during and after wartime, reinforcing the need for diversification beyond a simple stock-bond split. Diversification and factor exposure as defense (Priority: 4/5): The hosts argue that global diversification and exposure to multiple expected return sources, such as small-cap and value, can reduce drawdowns and improve recovery compared with concentrated country exposure. Risk management before a crisis (Priority: 4/5): Dimensional’s response is presented as an example of proactive risk management through market selection, listing standards, ADR structure, and underweighting Russia well before the crisis.

Key Arguments: Wars tend to reduce expected cash flows and increase risk, which can depress prices and raise volatility, but they do not reliably predict which assets will do well or badly. The most extreme historical investor losses came from expropriation and revolution, not simply war, as shown by Russia in 1917 and China in 1949. Some countries and asset classes did very well during wars, including U.S. and UK stocks in World War II and Japanese stocks in World War I, showing that outcomes are not uniform. Historical evidence suggests investors often learn the wrong lesson from one war and make new mistakes in the next because each conflict is different. The biggest global market crashes were in peacetime crises such as 1929, 1973, 2000, and 2008, so war is not the primary source of the worst drawdowns. Bond markets can suffer deep, long-lasting real losses during wartime and inflationary periods, so bonds are not guaranteed safe havens in real terms. Global diversification has historically provided resilience: broad world equity returns remained positive over the very long run despite wars, revolutions, depressions, and pandemics. Risk management should happen before a crisis through portfolio construction, market access standards, and security selection rules, not through reactive trading during the crisis.

Data Points: Recording date: Saturday, February 26 - The hosts note the discussion is being recorded during rapidly evolving events in Ukraine. International political crises in sample: 440 crises - Used in the 2006 paper 'War, Peace, and Stock Markets' covering 1918-2002. Crisis frequency: Almost once every two months - Average onset rate of international political crises in the database. World stock market impact from crises: Approximately 4% per year lower returns - Estimated reduction in world stock market returns associated with international crises. Country stock market reaction at crisis onset: About -2% - Average stock market drop for countries directly involved when a crisis starts. Monthly crisis drag: About -1% per month - Additional average decline for countries involved while a crisis lasts. Volatility change at crisis onset: Slightly more than one-third higher - International crises increase volatility relative to average levels. Volatility change when crisis ends: Slightly less than one-third lower - Volatility partially normalizes after crises end. Russian Revolution investor loss: Close to 100% - Assets were expropriated after 1917; Russian bonds were effectively zeroed out in the dataset. Chinese Civil War investor loss: 100% - Assets were expropriated after the 1949 end of the civil war. St. Petersburg vs. NYSE wealth: About 2x ending wealth - Investing in St. Petersburg stocks from 1865-1917 outperformed the NYSE over that period. German stocks in World War I and aftermath: More than -90% real USD value (1914-1922) - German equities were devastated during and after World War I. German stocks during World War I: -67% cumulative - Price decline over the war period itself. U.S. stocks in World War I: -18% real terms - U.S. investors lost money during World War I. UK stocks in World War I: -17% real USD / -36% local real terms - UK investors did worse in local currency; USD results benefited from pound appreciation. Japan stocks in World War I: +63% cumulative real USD - Japanese equities rose strongly during the war period. Global stock market in World War I: -31% real USD - World equity performance from 1914-1918. German stocks in World War II: More than -90% (1939-1947) - Equities were nearly wiped out during and after WWII. Japan stocks in World War II: Nearly -99% real USD - One of the most extreme market collapses discussed. U.S. stocks in World War II: +22% real - Local U.S. investor returns during WWII. UK stocks in World War II: +34% real - Local UK investor returns during WWII. Global equity investor during WWII: About -15% real USD - Broad global diversification reduced but did not eliminate losses. U.S. small-cap value premium vs U.S. market: +12% annualized - From 1939-1947, small-cap value outperformed the broad U.S. market. U.S. value premium vs U.S. market: +6% per year - From 1939-1947. German stock market recovery post-WWII: +61% per year real USD (1949-1959) - Strong rebound after devastation. Japanese stock market recovery post-WWII: +28% per year (1949-1959) - Strong postwar recovery after massive losses. Japan recovery horizon: Until 1969 - It took about 10 years after 1959 to recover the real purchasing power of a 1939 investment. U.S. long-term bonds drawdown: -67% real value - Starting in December 1940; recovery took until 1991. UK long-term bonds drawdown: -74% real value - Starting in October 1946; recovery took until 1993. Long-run global equity return: 5.2% real per year - Historical world equity return over 121 years. Inflation assumption over period: About 3% - Approximate average inflation in Canada and the U.S. over the long sample. Approximate nominal global equity return: About 8% per year - Derived from 5.2% real plus ~3% inflation. Political crises in database since 1918: 487 crises - The database had been updated beyond the original paper. Russia weight in many EM funds: 2.5% to 3% - Approximate benchmark weights in Vanguard/iShares emerging market portfolios. Dimensional Russia weight: 1% to 1.5% - Underweight since 2014 after lowering in 2013 due to property-rights concerns.

Pivotal Quotes: "War is clearly a humanitarian tragedy, first and foremost." — Benjamin Felix: Opening framing of the episode, emphasizing the human cost before market discussion. "In short, there is no simple recurring pattern. Investors did try to learn from history in the late 1930s, but they mainly learned how to make new mistakes since the lessons of the previous war proved to have only limited relevance to the next one." — Neil Ferguson: Quoted by the hosts to explain why historical war data is not useful for simple market timing. "The worst historical global stock market returns have occurred in peacetime." — Benjamin Felix: Central takeaway used to argue that wars are not the main source of the biggest market crashes.

Implications: Listeners should avoid war-based market timing and instead focus on asset allocation, diversification, and long-term discipline. Crises are inevitable; preparation matters more than prediction.