Regime Risk in Investing

(The following is outside my usual topics but its an area of my expertise that I have not found anyone else talking about).

Wise investors use diversification to reduce risk. Any one investment might fail for many different reasons, but many different investments are unlikely to fail together. Additionally, what causes one investment to do poorly often causes others to do well. Rising energy prices hurt manufacturing (which buys energy) but not energy companies (which sell it). Rising wages hurt employers with many low-wage employers, but benefit businesses who sell to consumers. Classically, bonds and stocks tend to move in opposite directions under a given type of pressure, so almost all long-term investors will benefit from holding some of both. For most of history opportunities for diversification were limited, and a prudent investor might buy several plots of land, invest in a ship’s cargo, and make some loans to neighbours. In the 20th century, mutual funds allowed small investors to own dozens of different assets for low but significant costs. Today anyone with a bank account in Canada can buy an index fund that holds thousands of different assets around the world for around 0.25% of their investments per year. However, most of these funds lack one important type of diversification.

Most balanced index investment funds in Canada invest 34-43% of their money in a single foreign country, the United States of America. Lets look at three examples that just buy everything in the index, and three that consider sustainability and business ethics but still have a low cost.

• XBAL, the iShares Core Balanced ETF Portfolio invests 35% of its money in the USA
• VBAL, the Vanguard Balanced ETF Portfolio, invests 36%
• ZBAL, the BMO Balanced ETF, invests 43%
• CSBA, the CIBC Sustainable Balanced Solution, invests 34% of its money in the USA
• GBAL, the iShares Environmental, Social, and Governmental (ESG) Balanced ETF Portfolio, invests 34%
• ZESG, a Balanced ESG ETF from the Bank of Montreal, invests 39%

Although prospectuses and fund facts don’t fully explain their thinking, by reading the personal finance literature we can make an argument for such heavy investing in the United States. The United States made up about 60% of the global stock market in 2024,¹ and the US stock market is very diverse and contains many companies with global markets. So most of these funds invest about 60% of their non-Canadian stocks in the United States. Financiers traditionally consider US government bonds as completely safe investments, so its common for index bond funds to contain some US government bonds in addition to Canadian. Many of these funds invest about 20% of their bonds in the USA. This argument overlooks one major factor.

Investments in the United States are at the mercy of a single political regime. Bad decisions by that regime can affect every industry and every type of investment in the country. The united Kingdom of Spain conquered a new world and discovered a whole mountain of silver. Philip II was the second greatest monarch in Europe and the third or fourth in the world. But the Spanish people and the Spanish economy did not prosper under this regime, because it was aristocratic and because its theory of how to use silver to create prosperity was inadequate to the problem. Argentina was as rich as Canada or Australia in 1913 and seemed ready to progress from agricultural exports to industry. Ever since it has fallen behind first the developed world, then Latin America. A series of governments, many of them juntas, made a series of bad decisions. The country has defaulted on its debts nine times since 1816. Czar Nicholas’ Russia was the emerging market of its day until it made the terrible choice of accepting a war with Austro-Hungary and Germany. Three years and two revolutions later Russia was taken over by Bolsheviks who nationalized the economy. Foreign investors lost everything.

Most of these stories involve monarchies, dictatorships, juntas, and one-party states. Japan, whose stock market crashed in 1991 and did not recover for thirty years, is ruled by the Iron Triangle of the Liberal Democratic Party, large corporations, and the civil service. Japan also takes very few immigrants and has been slow to bring in equality of the sexes. These things were even more true in the 1980s and 1990s. Its not surprising that a country ruled by a few hundred men from a few dozen families, educated at the same universities and employed by the same organizations, had trouble dealing with their stock-market crash. Thomas Watson Sr. was not the only American who thought that Nazi Germany’s high government spending and low unemployment made it a wonderful place to invest. That turned out to be mistaken after the Nazis stole everything that a stronger Nazi had not stolen already then went to war against the world.² The United States is no longer a lawful country where a wide variety of people have a voice and those who make poor decisions are removed from power by peaceful means.

Indexing can deal with the gradual decline of any one company, sector, or country by slowly moving money elsewhere. It cannot give you your money back if you invest it in something which collapses in value. This is why investors in small and medium-sized countries often use capped indexes of their local stock market which limit the investment in any one company. They do not trust the market that if one company is 10% of the national stock market, then they should trust it with 10% of their money (although they do trust that if it is 1% of the national stock market, they can trust it with 1%).

Canadian personal finance literature is full of warnings that you should not just invest domestically, because sometimes the Canadian stock market does well and sometimes it does poorly.³ It is not as full of warnings against heavy investment in any one foreign country. However, investing too much of your money in one country is like investing too much in one company or one economic sector.

Many companies listed on the US stock market are global and have branches which would not be hurt by poor sales or high costs in the USA. However, the global reach of American companies like Mastercard and Microsoft is tied to American hegemony. The US government finds it very useful to be able to read everyone’s emails by wiretapping just one company, and to be able to block payments around the world by sending a memo to Visa and Stripe. Foreigners watch Disney+ and Marvel movies because they think American culture is cool. Bad decisions by a single regime could undermine all of these things. Trips from BC to the United States have fallen about 40% since last year and I do not expect that trend to change for years. In addition, as long as the executives and critical assets of those companies are based in the United States they are subject to extortion.

In my view, it is very risky to invest 34-43% of your money in one foreign country with a faltering authoritarian regime. So in August 2025, I have made the second major change in my investment strategy since 2013, moved away from one-fund solutions, and bought a collection of investments that limits regime risk.

I do not think that any strategy could make investing in the 21st century safe. Even the insurance industry is issuing warnings that they may not be able to insure projects in some regions as climate change accelerates. But not investing too much in any one security, any one sector, or any one country reduces your risk.

(scheduled 14 August 2025)

1. Elroy Dimson, Paul Marsh, and Mike Staunton, Global Investment Returns Yearbook 2024: Summary Edition (UBS, 2024) figure 2 ↩︎
2. Two takes on this period are Tooze’s Wages of Destruction and Douglas Miller, You Can’t Do Business with Hitler (1941) https://archive.org/details/youcantdobusines0000doug/ Check out pages 71-80 on how many countries, not just the USSR, delivered goods to the Nazis in exchange for promised payments in kind, only to discover that those goods never arrived or were offered at a very high nominal value. Dan Davies calls this a bust-out fraud, and when gangsters take over a whole country, their petty frauds can become grand. ↩︎
3. A useful keyword is home bias, and one report recommending that Canadians put 20-40% of their stocks in Canada is “Canadians reducing home bias, eh? Vanguard research finds that investors are increasingly going global,” Vanguard Investments Canada, July 2023. They don’t provide the information to test or reproduce their claims because standards for those things in the finance industry are low. Unbelievable as it sounds, most advice for portfolio creation until a few years ago was based entirely on US data! Wise people noted that this was obvious success bias, because if the USA had defaulted on its debts, been conquered, or gone communist any time in the last hundred years, it would not be the center of global capitalism publishing the most popular theories of how to invest. ↩︎