St Petersburg Stock Exchange 1865-1917: Why diversification pays in emerging markets

Take a look at the chart below. Which of these two countries was the better investment?

On a very quick glance, it looks like the red line is the clear winner. But once you’ve checked the legend and dates, you’ll know it’s not so simple.

The chart shows the returns on the St Petersburg Stock Exchange and the New York Stock exchange from 1865 to 1917 (the data is in US dollar terms and excludes dividends). During that period, Russia clearly outperformed the US.

That may be less surprising than it sounds. Russia was a big development story in the late 1800s and early 1900s. It had around the sixth largest stock market in the world and was a major receipt of foreign loans and investment, especially from France.

The term emerging market didn’t exist back then. But in modern terms Russia was definitely a hot emerging market story along with Argentina (and, in some senses at least, the USA).

Then we get to 1914 and the market shuts down for the First World War. Shortly afterwards comes the Russian revolution and at that point the St Petersburg stock market simply ceased to exist.

On the far right, you can see the brief moment in 1917 when it reopens for two months, before the revolution in March 1917 saw it close again for good. Investors who had not got their capital out of the country in time lost it all.

Diversifying against disaster

This makes a key point about diversification. We don’t diversify to get better returns or even avoid small ones. We diversify to avoid being overwhelmingly exposed to unlikely but potentially catastrophic losses – like a revolution that sweeps away everything.

This Russia chart is striking because we can see how good an investment the country had been, up until the point when it suddenly wasn’t. It’s very unusual to get old data for emerging markets like this (it comes from a project by researchers at Yale: St Petersburg Stock Exchange 1865-1917).

But even without the numbers, we know it was the same story of total loss in countries such as Hungary, Czechoslovakia and Poland in Eastern Europe, as well as the Shanghai stock exchange in China. In the latter case, shares reportedly rallied sharply in 1949 after it became clear that the communists had won the civil war, because investors believed that the chaos of the KMT’s rule was finally over. That proved much too optimistic.

Investment is severely subject to survivorship bias. We don’t notice the countries or companies that went wrong as clearly as the ones that survived and thrived. Most of our judgments about what we can expect are based on the success stories.

For example, the long-term real return on the US market – about 6.5% per year – is often taken as what we can expect from equities, even though the US was one of the most successful stock markets over the past century and one of the most successful development stories. It’s very dangerous to assume that all today’s favourite emerging markets will turn out the same way.

No matter how convinced we are about China or any other emerging market, it makes no sense to commit too much to it because something completely unexpected could change everything. An investor in Russia might have looked smarter up to the end of the chart above, but one who had split his bets between Russia and the US would have looked more prudent from then on.

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