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Geographic Diversification Can Be a Lifesaver, Yet Most Portfolios Are Highly Geographically Concentrated

  • Melissa Saphier
  • Karen Karniol-Tambour
  • Pat Margolis

The best way we know to earn consistent returns and preserve wealth is to build portfolios that are as resilient as possible to the range of ways the world could unfold. To uncover vulnerabilities that are outside of investors’ recent lived experiences, we find it valuable to stress test portfolios across the various environments that have cropped up across countries throughout history.

One common vulnerability is geographic concentration. In the past century, there have been many times when investors concentrated in one country saw their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets in other countries remained resilient. Even without such extreme events, there is always a big divergence across the best and worst performing countries in any given period. And no one country consistently outperforms, as outperformance can lead to relative overvaluation and a subsequent reversal. Rather than try to predict who the winner will be in any particular period, a geographically diversified portfolio creates a more consistent return stream that tends to do almost as well as whatever the best single country turns out to be at any point in time. So geographic diversification has big upside and little downside for investors.

Geographic diversification is likely to be more important in the coming decades than it has been in our lived experience as investors. Through most of our working lifetimes, countries’ economies and markets have become increasingly intertwined due to globalization and the free flow of capital, under the auspices of the US as a dominant economic force and keeper of a stable global geopolitical order. Looking ahead, China’s ascent as an independent economic and financial center of gravity with an independent monetary policy and credit system is highly diversifying, making the world less unipolar and less correlated. At the same time, the rising risk of conflict within and across countries also increases the chances of divergent outcomes. Additionally, geographic diversification felt less urgent during the recent decade of great returns for most assets and portfolios. Low asset yields going forward make diversification and efficient risk-taking all the more important to investors.

To illustrate the impact of geographic diversification, we begin by looking at the characteristics of return streams from single countries relative to weighting a portfolio equally across countries, rebalancing annually. The chart on the next page shows cumulative returns above cash back to 1900 for the equity markets where we have reliable data going back over 100 years. An investor concentrated in Russia or Germany in the early 20th century would have lost most or all of their wealth, while an equally weighted mix of the five countries shown below does almost as well as the best performer.

Equity Market Cumulative Excess Returns Since 1900 (ln Scale)

Looking at a broader set of stock and bond markets back to 1950, you can see that an equally weighted mix has consistently performed well. And while no single equity market has suffered as much as Germany and Russia did in the first half of the 20th century, there is still a broad range of performance across countries, with the US fluctuating like any other country. In the charts below, the gray lines represent individual countries, with the US called out in dark gray, while the equally weighted mix is shown in red.

Cumulative Excess Returns (In)

Individual Countries
USA
Equal Weight

The geographically diversified portfolios do so well because they minimize drawdowns, creating a much more consistent return stream that allows for faster compounding.

Drawdowns (Excess Returns)

Individual Countries
USA
Equal Weight

This basic picture holds through time regardless of the starting point, as shown in the following charts of the 10-year rolling return-to-risk ratio across individual countries and a diversified portfolio.

Rolling 10-Year Return-to-Risk Ratio

Individual Countries
USA
Equal Weight

Even when we create portfolios that are diversified across economic environments (what we refer to as an All Weather mix of assets, balanced to perform equally well when growth or inflation are rising or falling), there is significant value to adding geographic diversification (as we do in our own All Weather portfolios). The charts below repeat the first two perspectives we showed above, this time for country-specific All Weather mixes as well as our own geographically diversified All Weather asset mix.

Country-Level and Global All Weather Asset Mixes
(Simulated, Gross Excess Returns)

Individual Countries
USA
Global All-Weather Asset Mix
Where shown the Global All Weather Asset Mix and Country-Level All Weather Asset Mixes are simulated. It is expected that the simulated performance will periodically change as a function of both refinements to our simulation methodology and the underlying market data. HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING OR THE COSTS OF MANAGING THE PORTFOLIO. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER OR OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. Past performance is not indicative of future results. Please review the disclosures located at the end of this page.

The Best and Worst Performers Naturally Fluctuate Through Time as Markets Move Toward Equilibrium Pricing

To get a better feel for what an investor would have experienced in any given period and how it compares to the longer-term range of outcomes, the table below looks decade by decade at how equity performance across countries stacks up. You can see the fluctuations through time; no one country is consistently outperforming, as outperformance can lead to relative overvaluation and a subsequent reversal. This decade, the US has been the best performer so far, but it was one of the weaker performers in the previous decade following the dot-com bust; it was one of the best performers in the 1990s, but before that you have to look back to the 1920s to find a decade in which US equity performance was better than middling.

Rankings of Equity Excess Returns by Decade

1900s

United States 83%
Equal Weight 9%
France 9%
Germany 9%
Russia -7%
United Kingdom -34%
Avg. Correl. 19%
Best - Worst 116%

1910s

United States 10%
France -35%
United Kingdom -44%
Equal Weight -54%
Germany -92%
Russia -100%
Avg. Correl. 3%
Best - Worst 110%

1920s

Equal Weight 249%
Germany 178%
United States 170%
Canada 134%
United Kingdom 87%
Spain 72%
France 41%
Sweden 24%
Avg. Correl. 26%
Best - Worst 225%

1930s

United Kingdom 6%
Germany 2%
Canada -9%
Equal Weight -10%
United States -12%
Sweden -22%
France -54%
Spain -61%
Avg. Correl. 37%
Best - Worst 68%

1940s

Spain 140%
Equal Weight 138%
Australia 132%
United States 122%
United Kingdom 117%
Canada 115%
Sweden 100%
France -19%
Germany -35%
Avg. Correl. 17%
Best - Worst 176%

1950s

Germany 739%
Japan 662%
Italy 484%
France 484%
Equal Weight 384%
United States 376%
Australia 277%
United Kingdom 270%
Sweden 240%
Canada 222%
Spain 98%
Avg. Correl. 20%
Best - Worst 641%

1960s

Spain 312%
Australia 148%
Equal Weight 75%
Japan 74%
Canada 71%
United States 41%
Sweden 31%
United Kingdom 28%
Germany 21%
Italy -1%
France -6%
Avg. Correl. 26%
Best - Worst 319%

1970s

Korea 456%
Japan 66%
Canada 30%
Equal Weight 10%
United Kingdom 8%
Switzerland -5%
Australia -12%
United States -17%
France -20%
Sweden -22%
Germany -31%
Spain -69%
Italy -74%
Avg. Correl. 38%
Best - Worst 530%

1980s

Sweden 503%
Korea 354%
Japan 310%
Spain 188%
Equal Weight 185%
Germany 179%
United Kingdom 173%
Italy 169%
France 158%
Switzerland 96%
United States 96%
Australia 39%
Norway 23%
Canada -4%
Avg. Correl. 46%
Best - Worst 507%

1990s

Switzerland 231%
United States 217%
Sweden 190%
France 117%
United Kingdom 110%
Spain 96%
Germany 92%
Australia 59%
Equal Weight 53%
Canada 52%
Italy 40%
Norway 2%
New Zealand -6%
Japan -47%
Taiwan -49%
Korea -66%
Avg. Correl. 50%
Best - Worst 296%

2000s

Norway 48%
Brazil 45%
Canada 42%
Australia 36%
Korea 22%
Spain 17%
Equal Weight 1%
New Zealand -3%
Switzerland -4%
Sweden -13%
Taiwan -23%
United Kingdom -23%
United States -27%
France -32%
Italy -35%
Germany -36%
Japan -41%
Avg. Correl. 74%
Best - Worst 89%

2010s

United States 182%
New Zealand 149%
Sweden 146%
Japan 105%
Germany 99%
Switzerland 97%
France 92%
United Kingdom 83%
Norway 78%
Equal Weight 74%
Taiwan 55%
Canada 54%
Australia 41%
Korea 27%
Italy 20%
Spain 11%
Brazil -26%
Avg. Correl. 65%
Best - Worst 209%

Geographic Diversification Can Be a Lifesaver

There are plenty of instances in which geographic diversification has been a lifesaver, preventing wealth from being wiped out. Below, we show a few perspectives on this. For each country, we looked at its deepest drawdown and how long it took to recoup the losses. There are plenty of instances where a given country’s equity market was decimated, and it often takes decades to recover from the losses. Most countries have worse drawdowns in their history than the equally weighted portfolio has ever had, despite many of them having track records that are decades shorter.

The equally weighted stock portfolio took material losses at times, but experienced drawdowns that were shorter and shallower, and it tended to recover faster than most individual country equity markets.

Worst Equity Excess Return Drawdowns Across Countries (USD Terms)

Country Data Starts Period of Worst Drawdown What Caused it to Happen Years to Recover From Start of DD Magnitude of Losses Equal-Weight Returns During Country DD
 
Switzerland Jan 1966 2007 - 2009 Global Financial Crisis 7 -51% -49%
Equal-Weight Jan 1900 1929 - 1932 Great Depression 13 -66% --
Australia Jun 1933 1969 - 1974 70s Inflation 10 -66% -17%
UK Jan 1900 1972 - 1974 70s Inflation 11 -72% -20%
Norway Feb 1970 1974 - 1978 70s Inflation 16 -74% -17%
Japan May 1949 1989 - 2003 Deflationary Grind 29 & Counting -75% -16%
Brazil Aug 1994 1994 - 1998 Balance of Payments Crisis 24 & Counting -77% 23%
Canada Jan 1919 1929 - 1932 Great Depression 16 -79% -65%
New Zealand Dec 1984 1986 - 1990 Currency & Constitutional Crisis 32 & Counting -81% -10%
Sweden Dec 1915 1917 - 1932 WWI and Great Depression 29 -81% -30%
Spain Dec 1915 1973 - 1982 Political Turmoil and 70s Inflation 26 -83% -19%
France Jan 1900 1944 - 1950 WWII 15 -83% 41%
Taiwan Jan 1988 1990 - 2001 Asian Financial Crisis 29 & Counting -85% 0%
United States Jan 1900 1929 - 1932 Great Depression 16 -85% -64%
Italy Jan 1948 1960 - 1977 Political Turmoil ("Years of Lead") 59 & Counting -87% 49%
Korea Jan 1965 1989 - 1998 Asian Financial Crisis 30 & Counting -91% 33%
Germany Jan 1900 1912 - 1923 WWI 47 -99% -62%
Russia Jan 1900 1912 - 1918 WWI and Bolshevik Revolution Never -100% -31%

While we focused on the stock market above, investors can of course suffer material losses being concentrated in other assets as well. One particularly egregious example is German bonds from WWI, which lost 95% of their value relative to cash in the year or so after Germany surrendered. Despite earning more than a 900% excess return since then, investors concentrated in German bonds in this period have never recovered their wealth.

German Bonds Cumulative Excess Return
(Indexed to after WWI Surrender, December 1918)

Geographic Diversification Is Likely to Be More Important in the Coming Decades Than It Has Been in Recent Decades

Over the past 40 years, economies and financial markets have been driven closer together by globalization and the free flow of capital, under the auspices of the US at the helm of the global economic and political order. So the past few decades of returns vastly understate the potential benefits of geographic diversification because of the unusual environment of high correlations across countries. As one indication of this, the chart below shows equity correlations across countries against the size of exports as a percent of the global economy back to 1825. The surge of globalization in the postwar era under US dominance, with rising trade and capital ties between countries globally, has led to unprecedented high correlations among the equity returns of different countries. In the past, there have been ebbs and flows in the pace of globalization including a period of rising trade tensions culminating in the world wars and of course we see rising anti-globalization sentiment resurging today.

World Exports and Average Cross-Country Equity Correlation

Average Equity Correlation
World Exports (%World GDP)

Going forward, rising conflict around trade and globalization may increase divergences across countries. Additionally, China’s ascent as an important economic and financial center with divergent secular conditions from much of the developed world (e.g., more ability to stimulate in the event of a downturn) raises the likelihood of an increasingly multipolar and less correlated world. All of these forces raise the importance of diversification going forward. The table below reflects how lowly correlated the Chinese economy and its markets have been.

Correlations to US Assets and Conditions

Asset Correlations Euroland Japan UK China South Africa Brazil Turkey
 
Equities 0.5 0.7 0.6 0.4 0.4 0.6 0.3
Bonds 0.7 0.5 0.6 0.4 0.3 0.1 0.3
Correlations of Economic Conditions
 
Growth 0.4 0.4 0.4 0.0 0.2 0.1 0.2
Inflation 0.8 0.6 0.8 0.0 0.5 0.1 0.3
Short-Term Debt Cycle 0.4 0.3 0.6 -0.3 0.1 -0.3 0.5
Monetary Policy 0.9 0.4 0.9 0.0 0.4 0.5 0.4

At the same time, global portfolio exposure to China is tiny, though it is growing as Chinese markets gradually open up, making significant geographic diversification easier for investors to achieve.

Developed world investors are similarly under-allocated to the rest of the emerging world and tend to have a large home country bias, leaving them geographically concentrated overall. Below, we show an example of a typical US investor portfolio’s geographic exposure.

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The information provided herein is not intended to provide a sufficient basis on which to make an investment decision and investment decisions should not be based on simulated, hypothetical or illustrative information that have inherent limitations. Unlike an actual performance record simulated or hypothetical results do not represent actual trading or the actual costs of management and may have under or over compensated for the impact of certain market risk factors. Bridgewater makes no representation that any account will or is likely to achieve returns similar to those shown. The price and value of the investments referred to in this research and the income therefrom may fluctuate. Every investment involves risk and in volatile or uncertain market conditions, significant variations in the value or return on that investment may occur. Investments in hedge funds are complex, speculative and carry a high degree of risk, including the risk of a complete loss of an investor’s entire investment. Past performance is not a guide to future performance, future returns are not guaranteed, and a complete loss of original capital may occur. Certain transactions, including those involving leverage, futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates could have material adverse effects on the value or price of, or income derived from, certain investments.

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