Democracy and Stock Market Returns

Abstract

This paper examines the relationship between the level of democratization and stock index returns in a sample of 74 countries. Compared with democracies, autocratic states are characterized by lower returns despite exhibiting higher return volatility. Even though this higher volatility can be mostly attributed to diversifiable country-specific risk, the Capital Asset Pricing Model is unable to explain the return differential. Instead, it is the level of investor protection that can fully account for the phenomenon described here. Autocratic leaders are reluctant to promulgate regulation shielding investors and the resultant risk of expropriation depresses the returns realized by outsiders.

Keywords: Stock Returns, Political Regimes, Democracy, Autocracy, Investor Protection

JEL Classification: G12, P16