Exhibit 2 below shows the market performance for high and low economic freedom groups formed from sorting countries annually on current year economic freedom score. Dimensional defined high (low) economic freedom countries as those whose economic freedom score is above (below) the median score for a given year.
In developed markets, high economic freedom countries had, on average, higher average returns than low economic freedom countries. In emerging markets, average returns were higher for countries ranking lower on economic freedom. But in both cases, the t-statistics for the return spreads indicated the differences were not reliable. These results suggest that even perfect foresight of future developments in economic freedom may not be useful for timing equity markets.
(For a larger view, click on the image above)
The core investment philosophy should be that, in liquid and competitive markets, where capital is free to move around the globe, security prices reflect the aggregate expectations of all market participants. Among the many considerations by market participants when setting prices are political risks, information about government spending in the economy, the strength of the rule of law and the regulatory framework under which the private sector operates.
Thus, investment decisions should not be based on countries’ economic freedom—the knowledge of which is already embedded in prices. A truly global perspective offers a broader opportunity to manage idiosyncratic risks of countries.
The bottom line is that your global equity allocation should look similar to how the “wisdom of crowds” (in aggregate, all investors) allocates capital. Today that is about one-half U.S., three-eighths developed non-U.S. and about one-eighth emerging markets. For those interested, the year-end 2018 CAPE 10 earnings yields (as good a predictor as we have for future expected real returns) was as follows: U.S., 3.6; Developed non-U.S., 5.8, and Emerging Markets, 7.3. (Data provided by AQR Capital Management.)
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.