Most people, given the choice, would prefer to live in a democracy. But what does democracy mean for equity returns? Do stock markets in democratic countries deliver better returns than those in countries with autocratic leadership? LARRY SWEDROE examines the academic evidence.
Nobel laureate economist Harry Markowitz is reported to have said that “diversification is the only free lunch” in investing. And the empirical research on the benefits of international diversification, including the 2019 study from Vanguard’s research team, Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation; the 2011 study by AQR’s Clifford Asness, Roni Israelov and John Liew, International Diversification Works (Eventually); and the 2021 study To Diversify or Not to Diversify Internationally? by Mehmet Umutlu and Seher Yargi, concluded that international diversification plays an important role in portfolio construction with the potential to reduce risk; a good starting point for investors is the global market-capitalisation weight; and while global diversification can disappoint over the short term, over the long term, which is far more relevant, “It is the free (and hearty!) lunch that theory and common sense says it should be.”
While economic theory and the empirical evidence favor building globally diversified portfolios, interesting questions for investors are:
- Do political institutions matter for the stock markets?
- Do the laws and regulations of democracies and democratic institutions impact stock valuations?
Xun Lei and Tomasz Wisniewski sought to answer these questions in their 2021 study Democracy and Stock Market Returns in which they examined the relationship between the level of democratisation and stock index returns in a sample of 74 countries covering the period 1975-2015. Their primary democracy measure was sourced from the Polity IV Project database: “This source first derives a democracy indicator measured on an eleven-point scale ranging from 0 to 10. Its design involves gauging the ability of citizens to express their political preferences, the extent to which civil liberties are guaranteed and the existence of constraints on the power of executive. Similarly, an autocracy variable, measured on eleven-point scale is constructed by focusing on competitiveness and regulation of political participation, procedures for executive recruitment and the constraints imposed upon them. In the final step, a POLITY score is derived by deducting the autocracy score from the democracy one.” As a robustness check, they considered an alternative democracy measure obtained from Freedom House, which publishes annual reports on the democracy and human rights situation in 192 countries. Freedom House’s definition of political freedom is “that people can freely participate in the political process by having the right to select a particular candidate in a legitimate election, to participate in political parties or organizations and to elect a representative who has a decisive influence on public policymaking and who is responsible for the electorate.” To control for the impact of economic environment on stock returns, macroeconomic indicators (GDP growth, GDP per capita and inflation) were incorporated in their regression analyses. Following is a summary of their findings:
- There was a positive relationship between democracy levels and stock returns, a negative correlation between democracy levels and volatility, and a negative correlation between stock returns and lack of political rights — compared with democracies, autocratic states were characterised by lower returns despite exhibiting higher return volatility.
- All else equal, a one percentage point increase in their Polity IV index resulted in an increase in the return of the MSCI index by 0.0705 percentage point (a fall of 100 percent in their democracy measure depressed stock returns by 7.05 percent per annum, all else equal).
- A “High Democracy Portfolio” (the top 10 percent) returned 9.83 percent per annum, while the “Low Democracy Portfolio” (bottom 10 percent) earned an annual return of only 5.29 percent, a gap in returns of 4.54 percentage points (though the gap was not statistically significant at the 5 percent confidence level, with the p-value equaling 0.0956).
- The investor protection measure (data on the strength of the investor protection index was from the World Economic Forum Global Competitiveness Index, maintained by the World Bank; higher values of the index represent more robust protection of investors’ rights) was positively correlated with democracy, and the extent to which investors are legally protected is predictive of future returns, fully explaining the higher rewards during periods of democratic government rule.
- Autocratic leaders are reluctant to promulgate regulation shielding investors, and the resultant risk of expropriation depresses the returns realized by outsiders.
Lei and Wisniewski noted: “The most striking finding that arises from our estimations is that democracy fosters investor protection.” They theorised: “Engagement in outright expropriation of firm assets, over-regulation, confiscatory taxation and solicitation of bribes could seriously undermine the chances of reelection for politicians wielding power in democratic nations. Autocrats, on the other hand, are largely immune from such considerations and, consequently, their incentives to expropriate are stronger.” They added: “We report that autocrats, unrestrained by democratic processes and motivated by their desire to abrogate private wealth, are unlikely to enact strong investor protection laws.” This is consistent with the findings of Quan Li, author of the 2009 study Democracy, Autocracy, and Expropriation of Foreign Direct Investment, who found that autocracies are more likely to expropriate foreign direct investments. Their findings led Lei and Wisniewski to conclude “that the level of investor protection is predictive of future returns and that investor protection alone is capable of explaining the returns gap between autocratic and democratic states.”
Lei and Wisniewski’s findings are consistent with those of Heikki Lehkonen and Kari Heimonen, authors of the 2015 study Democracy, Political Risks and Stock Market Performance, who examined the performance of 49 emerging markets spanning the period 2000-2012 and found that democracy and political risk does impact equity markets — decreases in political risk lead to higher returns.
One issue that was not examined was the impact of rising or falling democracy scores. Given that rising scores would reduce risk, that should lead to higher valuations, driving the historical returns higher while reducing future expected returns. Perhaps their findings were impacted by changes in the scores.
Lei and Wisniewski’s findings suggest that because stock investments in more autocratic countries have provided lower returns with higher volatility and have been accompanied by expropriation risk, investors should underweight these countries in their portfolios. Investors wishing to minimise expropriation risk should consider screening out autocracies from their portfolios, or at least minimise exposure to them. And some risks are just not worth taking, no matter the risk premium. Expropriation risk might be one of them. For example, Dimensional has long screened out countries where they view investors do not have sufficient protections.
With that said, it is important to note that Lei and Wisniewski’s findings cannot be viewed as a manifestation of a risk premium — since investor protections reduce risks, we should expect a risk premium to be present for autocratic countries. Yet, the opposite was true. In other words, we have an anomaly, as greater risk should be accompanied by higher expected returns — raising the question of if we should expect their findings to persist. Alternatively, the market may have driven valuations of democracies higher (helping to increase their returns) and valuations of autocracies lower in recognition of the risks (negatively impacting their returns), and then investors should expect a risk premium.
Finally, for the increasing percentage of investors choosing to align their portfolio allocations with their personal values by adopting ESG (environmental, social and governance) strategies, the evidence that democracies have provided higher returns provides further support for avoiding investing in autocracies.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-332
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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