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Do You Know the Widow-Maker of the Investing World?

By Motley Fool Staff – Nov 27, 2016 at 12:13PM

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Investors have been betting that Japanese government bonds will plunge for decades. And it continues to be a losing bet ...

In this segment from Motley Fool Answers, the cast talks about a few "that will never happen" moments in the world of economics and finance that -- surprise! -- actually happened. This time, the team has an opportunity to look at arguably the most famous widow-maker trade, a bet on rising interest rates for Japanese government bonds.

Tune in to find out how Japan has managed to stay afloat and reduce its debt from record-setting levels.

A transcript follows the video.

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This video was recorded on Nov. 1, 2016.

Alison Southwick: They said Japan will never get out of its debt hole. And when I say "debt hole" like that, it sounds really naughty, doesn't it?

Jim Royal: Uh-oh. Where's your mind at?

Southwick: Excuse me.

Royal: Yeah.

Robert Brokamp: I have no idea what you're talking about, but go ahead.

Southwick: It sounded aggressive. All right, whatever.

Royal: Investors have been betting against Japan for a couple of decades. They call it a widow-maker trade, because investors have been betting against Japan escaping this debt black hole.

Brokamp: And by the way, the widow-maker is a term that was first applied to the heart, or the left artery, because when you get blockage there, you're going to die, and that's why they call it the widow-maker. It's applied to this trade because these people -- if I understand this right -- are shorting Japanese bonds ...

Royal: Right ...

Brokamp: ... because they think they have to. They have to. The market's going to collapse. But it doesn't happen, so it's causing these people heart attacks because they're making these big trades that are just not paying off.

Royal: And just losers. And every once in a while there's somebody who comes up [and says] this is finally going to be the year where it ends, and just consistently, it's been a losing trade. In fact, what's happening now is that the Bank of Japan is buying that debt from private holders (just normal investors) and "monetizing" it. Putting cash back out there.

And what's happening now, in fact, is that Japan is rapidly reducing the amount of its public debt that's held by public investors ... the fastest in the world, in fact. So the hope, the expectation is that you're going to put more money out there, and people are going to be able to spend it. And to some extent, the U.S. has been doing that, too.

Really, the question is, does that work? There's the expectation that this is going to continue for at least the next few years, and at that point, debt that's going to be held by private investors is going to be about 100% of GDP. Previously, it had been close to 200%. But what's the endgame, here? Does the Bank of Japan cancel that debt? Don't know. It's really unclear what the endgame, what the final result of this is going to be. But investors who thought this is a sure, slam-dunk investment have, for 20+ years, gotten killed.

Brokamp: Japan's an interesting story for a couple of reasons. First of all, it's really the question of how much debt can a country have and still function?

Royal: Right.

Brokamp: And they keep exceeding expectations in terms of how much debt you can have and still function. And the other thing about it is we talk about being long-term investors here at The Motley Fool. Japan, up until maybe two or three years ago, is the second-biggest economy in the world -- so, a significant economy. The Nikkei, which is its primary stock index, reached almost $40,000 in 1989. Where is it today? $17,000. So, it's less than half where it was 27 years later. It just [changes] the whole perspective [about the benefit] of long-term investing, and that sometimes, even if you hold on for decades, an investment doesn't pan out.

Royal: Right.

Southwick: We're rooting for you, Japan.

Brokamp: Yes. We hope you can figure it out, because we're heading in that direction, at least in terms of debt. So, you make it work so we can figure out how we can make it work.

Royal: Now we say Japan is 20 years in the future.

Southwick: Oh! They are. They are in the future. What is the lesson, here, for everyone, and for all the Cubs fans out there?

Brokamp: For me, the lesson is, we make a lot of our investment decisions based on history. We invest in stocks for the long run because there are plenty of articles and sites that show that if you buy the stocks, and you hold on for a long time, you do all right.

But sometimes, things happen that have never happened before, so you have to be prepared for scenarios that haven't happened in the past, but could happen in the future. And for me, that means being very diversified in your portfolio so that if something does blow up, you have something else that will do well.

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