If America could some how magically transfer all its managerial know-how to every nation, world GDP would rise nearly 300 percent. There are a host of obstacles standing between us and this prosperity boom: lack of education, lack of infrastructure, oppressive or profligate governments, and protectionist policies. Yet there is a force which has the potential to overcome these obstacles, the force of the global capital market. The process of globalization has indeed been going on for decades, but there is new evidence that the world’s capital markets are now reaching critical mass. They are poised to fuse into a global capital market which can discipline governments, transport capital where it is needed, and transform the way people live and do business in every corner of the globe.

We are about to enter into an era of explosive growth and change as a result, but the journey to prosperity will not be entirely smooth. The capital market will force governments to cut unsustainable entitlement policies including pensions, subsidized healthcare or welfare, and force businesses dependent on government protection to restructure or perish. There are likely to be massive job losses and great social and personal dislocations as these changes take place. The turmoil will be the greatest in Europe and in the developing countries, but even the United States is likely to face some of this coming social unrest.

The following piece, excerpted from Lowell Bryan and Diana Farrell’s new book Market Unbound: Unleashing global capitalism, lays out some of the practical implications these trends have for individual investors.

People are always asking where they should invest their money. Anyone with savings is a capitalist; we all want better returns for less risk. But this is a hard question to answer because it depends on the capital, investment skills, access to information, free time, appetite for risk, and investment objectives of the individual saver.

To complicate matters, the increasing integration of the global capital market calls on investors to broaden their perspective from their home country to the world economy as a whole. In effect, they must become global capitalists. Yet this way danger lies. The global foreign exchange, bond, and derivatives markets are teeming with sharp professionals who have excellent tools and superb information at their disposal. Powerful enough to move markets simply by virtue of the financial resources they command, they are far too adept to be outwitted by the amateur.

The real opportunities are in equities. The next 20 years promise to be a golden age for equity investment. Trends at work in the global economy are likely to lead to productivity gains that will translate into real earnings increases and thus into higher equity values.

Buy stocks

For as long as reliable records have been available, the equity markets have generated better returns than the bond or money markets or bank deposits. Over the past 70 years, US equities have earned a real average annual rate of return of 6.9 percent; long-term Treasury bonds, on the other hand, have earned 1.7 percent, with three-month Treasuries turning in only 0.5 percent. One US dollar invested in 1925 would have yielded just $3.10 in real dollars in 1994 if it had been invested in long-term US bonds, but $97 if it had been invested in stocks. And both equities and bonds have outperformed money in the bank for at least 50 years.

As foreign investment spurs the global transfer of superior techniques of production, equities will capture the benefits

Equities are set to become even more attractive over the next two decades. As foreign direct investment spurs the global transfer of superior techniques of production, it is equities that will capture most of the benefits. Highly productive companies that lead their industries in globalizing will be able to capture extraordinary returns by expanding, acquiring other companies, or licensing their technologies. Even less productive companies in countries that have little history of competition can do well if they have a unique valuable asset such as a customer base, a distribution system, or employee skills. They can either capitalize on that asset themselves, or license or sell it to someone else that can make good use of it.

Because the equity markets are not yet fully integrated, they are more accessible to ordinary businesspeople than to professional traders. Investing capital to transfer superior techniques of production globally—which involves disaggregating not just foreign exchange and interest rate risks, but also operating risks such as labor, production, regulatory, and legal risks—is best undertaken by knowledgeable business managers. Simply buying the equity of a company with strong line management, superior production techniques, and a global outlook can allow you to tap into a rich flow of global anomalies in markets for goods and services.

Much juice can still be squeezed out of equities just by getting businesses to perform better. Outside the United States, few companies have experienced much pressure to improve their performance. As global investors begin to exert such pressure, companies will develop the ability to deliver large returns to shareholders. Much embedded value will be released if they restructure, spin off assets, or eliminate the cross-subsidization of weak businesses by strong ones.

Another reason for the growing allure of equities is the expected surge in savings for retirement. Despite overwhelming evidence to the contrary, US households show an irrational preference for "safe" bonds, bank deposits, and money market funds over "risky" equities, especially where their retirement savings are concerned. This prejudice produces cheap debt, which can be leveraged by equity to increase returns. As the populations of the developed world near retirement, their preference for bonds and bank deposits could deepen—an effect that could increase year after year as retired people come to account for a larger share of the population.

Because the global equity markets, unlike the bond markets, are still integrating, diversification across countries still pays off. It allows investors to earn high returns while reducing their risk, since prices are not heavily correlated from one market to another. While this benefit will fade as markets integrate, it will remain important for at least the next decade, probably far longer.

As more companies become global, risk-adjusted returns on equities should improve overall

Corporations that compete globally also generate better returns than those confined to their home country because they can seek out markets where they have a competitive advantage and avoid those where they are disadvantaged. Investing in these global players not only increases returns, but also provides protection against political or other risks in any one country. Going global enables businesses to reduce their domestic risks through diversification, especially if they are based in heavily indebted nations or emerging markets. As more companies become global, risk-adjusted returns on equities should improve overall.

Finally, equities are attractive because of their responsiveness to active management. In an open global system, a change in a company’s circumstances will spur managers to action. By contrast, once a bond has been issued, the only thing that can adjust to changing conditions is the price. Thus, equities have "self-hedging" characteristics that bonds do not share.

None of this implies that you have to invest in equities as a class. While investing in country index funds can be a successful strategy, you may prefer to look for specific stocks instead. As equity markets are not yet integrated and perfect, opportunities exist to seek out individual stocks, particularly in countries where information is not readily available. Even in a sophisticated market like the US, investors such as Warren Buffet have demonstrated that you can successfully pick individual stocks.

Throughout the world, there are many companies with attractive franchises that are not capitalizing on their global opportunities. They may be unaware of them, or afraid to expand, or unwilling to consider opportunities away from home. With a little work, it should be possible to identify companies with production advantages that can be exploited worldwide, especially in emerging global industries such as retailing, fast food, healthcare, and auto repair. Even in industries where global companies are already operating—say, consumer packaged goods with giants like Unilever and Nestlé, or energy with Shell and Exxon—opportunities abound.

Regardless of which currency is the base for your investments, US equities should probably be the backbone of your portfolio. As the most competitive market in the world, the United States has the largest proportion of companies with world-class productivity advantages, and the biggest, deepest equity market with the best protection for the investor. If you are a dollar-based investor, investing in US companies that are expanding worldwide allows you to capture global productivity advantages without having to take foreign exchange risks; the companies do that for you. The alternative, investing in non-US equities, means that you either have to manage foreign exchange risks through other financial instruments yourself or assume those risks directly.

On the other hand, most investors should be wary of investing in the equities of companies in emerging nations. These markets are still insider markets where outsiders are at a distinct disadvantage. Moreover, they are thin and prone to spectacular booms and busts, making even mutual funds investment risky for anyone without professional management. The companies themselves often have inferior production techniques and are unlikely to be competitive unless they can import superior methods from elsewhere. It is usually more rewarding to invest in developed-world companies with proven technologies that are making foreign direct investment in developing countries than to acquire personal stakes in these countries.

Stock market crashes as devastating as those of the 1920s and 1930s could be in store

Even US equities are not without risk. By early 1994, the Dow Jones index stood at under 4000; by the end of 1995, it had risen to well over 5000. The market may be temporarily overvalued, or it may be starting to respond to the powerful forces of globalization. Only time will tell. Equally, a major correction in the world’s equity markets may be brewing; worse still, stock market crashes as devastating as those of the 1920s and 1930s could be in store. All the same, we believe that over the next decade or two, equities will be unusually attractive relative to their risks.

Shun bonds

We expect the global bond market of the near future to be extraordinarily turbulent. Price volatility will be high, with some national governments experiencing market crises as a result of persisting fiscal imbalances. Such entitlements as state-funded pensions and healthcare will prove difficult to cut as populations age, particularly in democracies. Over the next 35 years, the proportion of retired people in the voting-age population of the United States and Germany will rise by 30 percent, to a quarter of the total. Italy will see an increase of over 60 percent, to a third of the total. These large voting blocks are unlikely to vote away their entitlements.

Scaling down unemployment and welfare benefits can be just as difficult. The inevitable conflict between the power of the market to control pricing and the power of the nation state to issue debt will be resolved in the global bond market. Cuts in state subsidies will be strongly resisted by the corporations that currently benefit from them.

As more and more long-term fixed-rate paper is issued by governments, the threat of crisis looms ever larger

As the global bond market grows and becomes more integrated, and as more and more long-term fixed-rate paper is issued by governments, the threat of crisis looms ever larger. Price volatility is likely to be exacerbated by social and political turbulence as nations grapple with declining entitlements and the lifting of product and market restrictions. Especially in the most indebted countries with the most generous entitlement benefits, we can expect sudden collapses of government, national strikes, and civil unrest. Their impact on the bond market will be incendiary.

In the most indebted countries we can expect sudden collapses of government, national strikes, and civil unrest

By the year 2000, when the stock of global financial assets will be some $80 trillion, any external shock will instantly prompt decisions all over the world to sell as soon as new information becomes available. When even a tiny fraction of a vast, integrated global market suddenly changes its mind about the attractiveness of a particular security, that security will become illiquid immediately until the price adjusts and the new information is fully processed. And if the evidence of Mexico in 1995 is any guide, this adjustment could be of the order of 30 percent or more virtually overnight.

While such extreme volatility holds for individual equities too, those of companies with globally diversified cashflows are far less exposed to country risk than are national bonds. Indeed, national government bonds are a pure play on that country. And now that bond markets are substantially integrated, they have incorporated much of the volatility that used to be absorbed by the foreign exchange markets. External shocks are bound to catch even the savviest market participants by surprise; anyone who is not active in the market has little hope of being able to react fast enough to avoid massive price adjustment.

Professional traders are skilled at taking aggregated risks, disaggregating them, and keeping only the risks where they have comparative advantage. This leaves the nonprofessional with the poorer risk-return relationships. If you want to participate in the markets dominated by traders—the foreign exchange, bond, and related derivatives markets—it is best to hire one of them to act as your agent through a mutual fund, a hedge fund, or an investment market advisor rather than participate directly, especially where the risk premiums are large. If a country’s government is paying a heavy real premium over the rates paid by the United States, Germany, or Japan, you probably should not take the risk. Many private US investors attracted by the apparently high returns on Canadian and Mexican country bonds in fall 1993 found themselves with huge losses in early 1994.

In an integrated global bond market, there are usually sound reasons for huge risk premiums. Unless you have the skills, tools, and information to disaggregate these premiums and take only those risks where you have a comparative advantage, you should stay away from them.

If you hate risk, can’t stomach the equity markets, and want only to earn the global risk-free rate of return, stick to US Treasury instruments—particularly the short-term varieties, which carry little interest rate risk. We like US Treasury bonds, especially for dollar-based investors who want to avoid currency risk. The United States has the youngest population in the developed world and the least generous entitlement programs, and has begun to demonstrate the will to get its budget to balance. With the world’s most competitive private sector, it is also in a position to benefit from most of the economic trends toward globalization. This means it should grow more rapidly than most other developed countries, making its debt burden less onerous.

Remember that in a globally integrated bond market, you are getting the real risk-free return no matter which country’s bonds you invest in. Everything else is either an inflation premium or a risk premium. If you gravitate to bonds because you don’t want to take risk, and you are a dollar-based investor, stick to US Treasury bonds.

What about cash?

With so much turbulence around, shouldn’t you just leave your funds in the bank? The answer is no. After adjustment for inflation, bank deposits have turned in break-even returns—if not actually negative ones—for the past 50 years. While losses on bank deposits are gradual, the erosion of your spending power is real nonetheless.

The risk-free rate of return—estimated as the US Treasury bond rate less the holding rate premium—is already low at under 2 percent, and could sink still further with the imminent surge in savings. Intermediation costs mean that bank deposits are likely to earn even less than this. In particular, interest rates on consumer bank deposits are likely to be low in major economies that are not yet experiencing serious debt problems, such as Germany, Japan, and the United States, because of the limited demand for loans in these countries. As their populations age, fewer people will borrow money, so banks will be awash with deposits and short of loans.

This demographic effect gives banks little incentive to pay much interest to attract depositors. Money market mutual funds will continue to offer slightly higher interest rates than banks, partly by taking some interest rate risks, but after fund management expenses have been deducted, they are unlikely to offer more than the global risk-free rate of return. It is hard to finance a comfortable retirement when you are earning less than 2 percent compound interest on your savings, unless you have saved an awful lot of money.

Should you, then, keep all your capital invested in equities? Again, the answer is no. We have painted a picture of a market in turmoil. Just as extreme price volatility is likely in the bond market, major corrections, even crashes, are possible in the stock markets. In such an environment, liquidity is critical. You don’t want to have to sell assets when prices are artificially depressed by overcorrections in the market. On the contrary, you need cash to buy assets at depressed levels—and to protect yourself if the world’s economy were to fall apart.

How much liquidity you need depends on your personal circumstances. If you have secure, diversified cashflows, or the skills and time to start again, you don’t need as much liquidity as someone who has already retired. You should also be aware of your own tolerance for risk. For some investors, keeping 10 percent of their assets in cash instruments may be all the liquidity they need. For others, it might be 50 percent. Only you can decide.

Active management

Some national equity markets could experience extreme volatility, with losses of 20% or more in a week or two

While we believe equities will be more rewarding than bonds and bank deposits over the next 10 to 20 years, this is only a directional strategy. If social, political, and labor upheavals translate into financial turmoil, some national equity markets could experience extreme volatility, with losses of 20 percent or more in a week or two. Though it is true that in the long term equities will outperform bonds, it is also true, as Keynes said, that in the long term we are all dead.

Most investors will therefore find it more comfortable and rewarding to manage the risk-return balance of their portfolios continuously. This doesn’t mean trading to capitalize on short-term price movements. Rather, it means continually adjusting your mix of assets—the proportion of cash, the balance between US and other equities—as conditions change.

Some people will find the confidence to invest more of their portfolio in equities when they have already made large gains, and are "playing with their winnings." Others will feel more secure immediately after a sell-off; these include "contrarians," who believe the market always overshoots and the time to buy is on weakness. Yet others are happiest when price-value relationships are nearing new lows, an approach known as "bottom fishing." Still others adopt a "buy and hold" strategy to avoid "churning" their portfolio and incurring heavy transaction costs.

If you keep losing money, it may not be just bad luck; you are probably playing against people with better judgment than you

Whichever investment strategy suits your personality and skills, you will perform better if you actively manage your portfolio. As you gain confidence in your understanding of the market and your decisions are borne out by price movements, you can become more aggressive in your portfolio mix. On the other hand, if the market keeps surprising you, a defensive posture will be a better bet. In some ways, investing is like playing poker. If you keep losing money, it may not be just bad luck; you are probably playing against people with better judgment than you. If so, you would do better to rely on a professional manager.

Even if your only decisions are which professionals to trust and which categories of assets to invest in, you still need to keep figuring out whom to work with and what portfolio mix you want. To pick individual securities yourself will take longer. At the heart of active management is gathering information, getting feedback from the market, and thinking. Make sure you understand the risks you are taking. Experiment with small amounts of money, not the bulk of your savings.

Keep on top of the market

Active management starts with awareness of what is going on in the market. That doesn’t mean watching computer screens all day. Nor does it mean trading your portfolio continually; transaction charges can quickly erode your returns. Rather, it means regularly following the market prices of your key investments so that you are prepared to move. If these investments are not performing as you expect, try to find out why. You can obtain a wealth of information simply by reading.

The most important thing to track is probably the relative value of equities as a class—not just the equities you own. You need to judge whether they are fundamentally under- or overvalued. In particular, track stock price indices against the earnings and cashflows of the individual indexed companies, and compare the dividends on stocks with the yields on bonds.

There are a few other key prices you need to know. Using statistics available on the back pages of The Economist, you can calculate the real inflation-adjusted returns on national government bonds. Simply take the annual increase in consumer prices and subtract it from the government bond rate. If a country’s real rates suddenly rise or fall, either the market is changing its assessment of risk or central banks are intervening. Whichever, you should be alerted.

Similarly, watch the yield curves. Are they steepening or flattening? If they are steepening without upward movements in short-term rates, the market is demanding a higher premium to take holding period risk. If they are steepening because of downward movements in short-term rates, it is probably because central banks are taking coordinated action to try to lower rates.

Gathering and thinking about such information can help you decide when to make adjustments in your portfolio. If you have invested heavily in a particular country’s equities, you may want to watch its bond markets—not so that you can invest in bonds, but to look for warning signs that trouble is brewing. If government bond yields shoot up and overtake corporate bond yields, it probably indicates that market professionals are worried about the risks in that country. If dividend yields are falling and bond yields rising, watch out: a "bubble" may be forming, and it may be time to get out of any equity investments you have in that country.

Watch what governments do, not what they say

National governments’ actions over the next few years will determine whether we face global prosperity or devastation

Although national governments are losing power to global markets, their actions over the next few years will determine whether we face global prosperity or devastation. Watch what they do, not what they say. Are they cutting entitlements and controlling their deficit spending, or not? Are they liberalizing product market restrictions, or not? The more govern-ments move toward reducing deficits and removing restrictions, the more likely are their countries to prosper, and the more attractive it will be to invest in them.

Expect volatility in equity markets

If you follow our advice and invest disproportionately in equities, you need to be prepared for stock market panics, manias, and crashes. As savings surge, there is a risk that stock market euphoria might lead to a mania, if not an outright bubble, in national stock markets—particularly the smaller, thinner ones in both the developed and developing world. We hope a bubble won’t develop in major equity markets, but even the US market is susceptible to overvaluation. If you believe any stock market is heading that way, take a defensive approach, such as boosting your assets in cash equivalents.

Even if there are no major market crashes, you should expect high volatility. Equity values are notoriously volatile, which is why diversification of risk is so important, and with equity markets not yet fully integrated, it remains an effective strategy. It has usually involved owning stocks in several national markets, but you may also want to diversify across industries in future.

Since national bond markets are linked to national equity markets, trends toward global integration in the former will naturally increase global integration in the latter. In some markets, such as that of the United States, these linkages are already close. This means that to achieve real diversification, you may need to spread your equities across industries whose stock price movements show little global correlation, such as pharmaceuticals, construction materials, and oil and gas production.

Another advantage of diversification is that you don’t need to spend so much time keeping on top of the market. If you put all your eggs in one basket, you had better make sure that basket is safe. If you are a dollar-based investor and want to invest in equities, but don’t feel confident in your abilities or lack the time to manage your portfolio actively, you should probably invest in a US index fund.

Have a contingency plan for the worst case

Unlikely though it is, a global economic crash is possible. If it starts to unfold, you need to be prepared. Think in advance about the safest haven you can find. Watching both market prices and government actions should equip you to judge whether a massive dislocation is likely. Although you can’t avoid all injury, you can protect yourself by deciding beforehand what your trigger points will be for taking defensive action such as shifting your investments out of equities and into short-term US Treasuries.

A global economic disaster would be devastating for everyone. But it is all relative. If much of the world’s wealth is destroyed, having preserved some of yours will give you an advantage as the economy is rebuilt. In the valley of the blind, the one-eyed man is king.