The link between democracy and long-term investment performance is becoming increasingly clear. As global democracy faces a troubling decline, investors must proactively account for the risks posed by exposure within their portfolios.

Much like an iceberg, the most obvious risks — investing in companies based in authoritarian nations — are just the tip of the iceberg. The larger, hidden risks lie beneath the surface, in the form of indirect exposure to countries that can undermine portfolio stability.

Democracy’s Link to Stronger Economies

Research, including insights from Nobel Prize-winning studies, shows that countries transitioning from autocracy to democracy experience, on average, a 20% increase in gross domestic product (GDP) over time. Democratic nations tend to foster better business environments, stronger legal frameworks and greater investor protections, all of which contribute to higher corporate performance and economic growth.

Investors over-exposed to authoritarian markets, however, may face greater risk, weaker corporate governance and opaque regulatory systems that can rapidly change the investment ability.

The Hidden Risks of Investing in Autocratic or Less Free Countries

Many investors recognize the visible risks of direct holdings in companies based in autocratic countries like China or Russia. However, what’s often overlooked is the larger, submerged portion of the iceberg: indirect exposure.

Take Russia as a recent example. Before international sanctions, many investors held direct stakes in Russian equities that were frozen and eventually removed at zero value from indexes when geopolitical events rendered Russia un-investable almost overnight. Even those without direct exposure faced significant losses, as companies with revenue streams or supply chains tied to Russia were hit hard. McDonald’s, for instance, had nearly 900 franchises in Russia before abruptly shutting them down due to sanctions. This unexpected blow to a global blue-chip company illustrates how indirect exposure can create material financial risk — even for investors who believed they had minimal investment in these markets.

Why Investors Should Be Paying Attention Now

Recent reports from V-Dem and Freedom House highlight an alarming trend: Democracy is retreating worldwide. According to Freedom House, global freedom declined for the 19th consecutive year in 2024. Sixty countries experienced deterioration in their political rights and civil liberties, and only 34 saw improvements.

This is not an isolated trend. Political shifts can quickly turn once-stable investment targets into high-risk markets. If a country becomes un-investable due to sanctions, economic collapse or government intervention, investors may find themselves stranded with devalued assets and no clear exit strategy. The 2022 Russia sanctions serve as a prime example; investors holding Russian equities were left with frozen or worthless assets without sufficient time to react.

While some investors attempt to manage this risk by bluntly excluding autocratic nations, a more effective approach is needed. As discussed in a recent Barron’s op-ed by Westwood’s Greg Behar, simply removing countries like China from an index does not eliminate risk — it often increases exposure to other authoritarian regimes. A more thoughtful solution reduces direct and indirect exposure to these markets while simultaneously enhancing exposure to democratic countries that have a commitment to secure government, due process and free press and markets.

Managing Direct and Indirect Exposure for Profile Stability

Many investors unknowingly leave their portfolios exposed to sudden market shocks by underestimating their ties to authoritarian markets. Even stocks listed in free-market economies can carry indirect risks through connections to these regimes. By adopting a more strategic approach — one that considers both direct and indirect risks posed by authoritarian influence — investors can enhance portfolio stability while benefiting from the economic resilience of democratic nations. A thoughtful approach to investing in democracies should consider:

• Selective country exclusions – Avoiding markets lacking basic civil liberties and democratic rights.
• Indirect exposure analysis – Identifying and managing risks in companies with revenue or supply chains tied to the removed countries.
• A diversified, rules-based strategy – Ensuring portfolio alignment with controls for beta, sector and tracking error.

By recognizing that investment risks extend beyond what’s immediately visible, investors can take a more proactive approach — avoiding not only the tip of the iceberg but also steering past the unseen risks that can sink a portfolio.