How to navigate geopolitical risks in your portfolio

By Larissa Fernand |  16-02-22 | 

In recent weeks, markets have been tossed back and forth by headlines around the potential for Russia to invade the Ukraine.

This kind of news falls under the umbrella of geo-political risk, which carries dynamics distinct from the usual challenges when it comes to investing, such as economic and corporate news or valuations.

This is nothing new. The India-Pakistan stand-off brought both sides close to war (2001), 9/11 terrorist attacks on the Twin Towers in New York (2001), war in Iraq (2003), the U.S. bombed Syria (2017), the North Korean crisis (2017), the sharp deterioration in relations between U.S. and China (2020), and the India-China border tensions over the past few years.

Geo-political risk can refer to a wide range of issues (military conflict between nations, a coup or uprising, climate change, Brexit). But in all of them, it creates uncertainty and instils fear. With geo-political risks, the market's short-term direction can change in a flash based on the latest headline.

Do read: More headlines do not always mean more risk

DAN KEMP, Morningstar Investment Management global chief investment officer, spoke to Marco Caprotti, editor and analyst for Morningstar Italy, on four ways investors typically handle geopolitical risks. 
  • 1) Predict and Gamble
  • Investors may try to predict the outcome of a geopolitical issue and then guess the impact it will have on investment markets.

If done successfully, it can make them seem to be a money-making master. But, more often than not, people get it terribly wrong. Positioning portfolios on this basis is a very dangerous game that is unlikely to align with investor goals.

Do read:  7 insights investors can learn from gambling

  • 2) Protection First
  • Faced with a specific crisis, some investors prefer to sit it out and wait; Loss Aversion in action.

If the worst-case scenario prevails, they feel like a conservative genius, having protected capital during the dark turning point. However, the problem with this approach is that the market is always throwing potential curveballs.

An investor who avoids the market on the basis of any potential event-risk could end up sitting in cash on a semi-permanent basis. This approach can be the most dangerous of all, with inflation further eroding cash returns and implying that one would be better off holding on and riding through short-term volatility.

Do read: Save like a pessimist, Invest like an optimist

  • 3) Holding Tight
  • A buy-and-hold mentality acknowledges one’s inability to predict events, and may help to keep investors’ minds trained on the long term.

This is far superior to the prior two approaches, not least because it keeps costs and turnover low, which are admirable traits that will ultimately benefit long-term investors.

That said, investors are inherently bad at it. Evidence suggests investors are susceptible to change amid market panic. No-one likes to lose 50% of their nest egg and that can move investors into the ‘protection first’ mode noted above. This tends to exacerbate any downturn and subsequently creates the potential for further mispricing opportunities.

Do read: Strategies to combat market impulses

  • 4) Valuation Stations
  • This approach considers the impact geopolitical risks would have on the intrinsic value of investment markets, and is based on a monitoring of the difference between price and that fundamental baseline.

This is akin to the ‘Mr Market’ analogy endorsed by Benjamin Graham and Warren Buffett, where an emotional human can often sell at prices that don’t reflect the underlying value. This approach is logically sound, but it requires a rational framework and enforced discipline.

Do read: Look at valuations, not index levels

What must be done?

A combination of the latter two approaches (3 and 4) is best, as they help investors to control their behavioral urges while concentrating their analysis on what matters most.

Understand the different scenarios presented by geopolitical tension and the impact they may have on the long-term fundamental drivers. The benefit of this type of analysis is that it creates a fundamental baseline that can be used to monitor how far market prices are moving and whether a contrarian opportunity or danger presents itself.

Investors are then able to recognize that heightened geopolitical tension is unlikely to materially shift the underlying fundamentals, creating an opportunity to buy something for less than it is worth.

The idea is to avoid action, except where it presents an opportunity, because fear-driven selling is rarely a good idea.

Do read: 4 questions to ask before you sell equity

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