How should you react upon learning that a country is in grave danger of being invaded by a hostile power?
Would “invest in that country’s equities” be at the top of your list? Of course not.
But try telling that to investors in the Taiwanese stock market. The Economist magazine recently referred to the country as “the most dangerous place on Earth.” On March 10, Admiral Phil Davidson, commander of the U.S. Indo-Pacific Command, warned the Senate Armed Services Committee that China could invade Taiwan within six years. In the two months since his testimony, the iShares MSCI Taiwan ETF (EWT) - Get Report has gained 12.6%, versus 7.5% for the S&P 500. (These returns include reinvested dividends.)
Note carefully that currency fluctuations account for only a portion of this ETF’s impressive performance. Even in local-currency terms, the Taiwanese stock market has outperformed the S&P 500.
Counterintuitive as this is, however, there actually is a straightforward explanation: Riskier assets require a higher expected return in order to induce investors into incurring that greater risk. From this perspective, it would have been surprising if Taiwan’s stock market did not outperform the S&P 500.
No Free Lunch
Note carefully that a risky asset’s higher expected return is not a free lunch, however. Its past return will have had to have been lower than otherwise, thereby transferring into the future enough potential gain to compensate investors for the higher risk.
A classic illustration of this relationship of the market to geopolitical risk was the U.S. stock market’s reaction to the Sept. 11 terrorist attacks, nearly 20 years ago. Not surprisingly, the market plunged in the wake of those attacks, since investors immediately started demanding a greater potential future return in order to persuade them to incur the additional risk of a suddenly very uncertain geopolitical environment. Only by falling in the present could the market promise a greater future return.
One measure of that greater expected future return was how quickly the market recovered. Investors who got into stocks at the post attack low gained 16.7% over the next seven weeks (as measured by the Dow Jones Industrial Average) -- equivalent to over 200% on an annualized basis. In retrospect, we might say that, only by holding out the prospect of a 16.7% seven-week return, could the stock market seduce skittish investors into returning.
To be sure, there was no guarantee that the market would mount this rapid subsequent recovery. A higher expected future return doesn’t guarantee a higher actual return. It’s precisely because a risky asset’s future is profoundly uncertain that it must hold out the promise that, if things turn out OK, it will reward investors handsomely.
Gamblers who play the odds immediately grasp this dynamic. A horse that is the long shot to win will pay off more if it does win than if the favored horse ends up winning. For example, Essential Quality, the horse that was favored to win this past weekend’s Kentucky Derby, faced 5:2 odds going into the race, while Medina Spirit, the eventual winner, was a long shot at 12:1 odds. That meant that a $2 bet on Essential Quality would have paid out $5 if it had won, while a $2 bet on Medina Spirit in fact paid out $24.
Assuming the stock market is efficient, a stock’s expected return at any given time will represent a fair trade-off between its risk and its return. A blue-chip stock with a strong balance sheet and a high dividend yield is relatively safe, for example, and its expected return therefore will be modest. In contrast, a wildly speculative stock that could either go bankrupt or become the next Amazon (AMZN) - Get Report — think GameStop (GME) - Get Report, for example — faces extremely long odds but will pay off handsomely if it’s successful.
Where you choose to be on this risk spectrum is therefore a function of your risk appetite. Regardless, though, make sure you do so in the context of a diversified portfolio. It’s possible that Taiwanese stocks will lose everything in a Chinese invasion, just as it’s possible that GameStop will go bankrupt. But a diversified portfolio of these long-shot bets should, over the long haul, pay off more than a portfolio of conservative dividend payers.
The bottom line: The stock market’s reaction to Taiwan being the “most dangerous place on Earth” is not such a mystery after all.