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)
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)
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
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)
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
|Best - Worst||116%|
|Best - Worst||110%|
|Best - Worst||225%|
|Best - Worst||68%|
|Best - Worst||176%|
|Best - Worst||641%|
|Best - Worst||319%|
|Best - Worst||530%|
|Best - Worst||507%|
|Best - Worst||296%|
|Best - Worst||89%|
|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)
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
2007 - 2009
Global Financial Crisis
1929 - 1932
1969 - 1974
1972 - 1974
1974 - 1978
1989 - 2003
29 & Counting
1994 - 1998
Balance of Payments Crisis
24 & Counting
1929 - 1932
1986 - 1990
Currency & Constitutional Crisis
32 & Counting
1917 - 1932
WWI and Great Depression
1973 - 1982
Political Turmoil and 70s Inflation
1944 - 1950
1990 - 2001
Asian Financial Crisis
29 & Counting
1929 - 1932
1960 - 1977
Political Turmoil ("Years of Lead")
59 & Counting
1989 - 1998
Asian Financial Crisis
30 & Counting
1912 - 1923
1912 - 1918
WWI and Bolshevik Revolution
|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
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|
|Correlations of Economic Conditions|
|Short-Term Debt Cycle||0.4||0.3||0.6||-0.3||0.1||-0.3||0.5|
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.