3 Tips for Managing Geopolitical Risk
Geopolitical Risk is an Evolving Concern for Investors
The world is never at peace for very long and geopolitical risks can have a tremendous impact on global investment portfolios. By understanding how geopolitical risks impact their portfolios, investors can avoid making potentially costly mistakes by overreacting to the market. These tips are especially important given the rising number of geopolitical risk factors moving into 2016, including the ongoing crisis in Syria, a potential Iranian conflict, and terrorism.
In this article, we’ll take a look at three tips for managing geopolitical risks.
#1 – Watch for a Flight to Safety
The most common response to a large geopolitical conflict is a flight to safety. For example, equities tend to experience a dramatic fall and the capital transitions into government bonds and safe-haven commodities like gold. The Japanese yen and Swiss franc are also well known safe-haven currencies that tend to draw capital during uncertain times. In fact, the Swiss franc was pegged to the euro in an effort to offset its appreciation during the sovereign debt crisis.
There are also a number of “financial” flights to safety that may be employed, including the CBOE Volatility Index (VIX), short equity exchange-traded funds (ETFs), or put options. Often times, the risk of a geopolitical conflict can be seen in VIX options and futures markets. Investors may also purchase put options in order to hedge their portfolio and offset the risk of a downturn, while speculators may purchase short equity ETFs to capitalize on any fall.
#2 – Commodity Impacts Will Vary
Geopolitical conflicts can have a profound impact on commodity prices. For instance, the price of oil rose from an average of $30 per barrel in 2003 to more than $100 per barrel following the Iraq war and a series of other geopolitical events leading up to 2008. The key point to remember in these cases is that Iraq was a major oil producer and the decline was largely due to the potential for supply disruptions that would lead to an increase in price.
Many other geopolitical risks don’t have a large impact on oil prices. For instance, the European sovereign debt crisis had a much bigger impact on currencies and bonds than commodities. Investors should take a look at the commodity exposure for a given country that the crisis is affecting and then determine the impact of that exposure on the global markets. Crude oil producing countries in the Middle East tend to be the largest commodity drivers.
#3 – Diversification is a Good Defense
The strongest defense against geopolitical risks is often strong diversification. With a presence in equities, commodities, and bonds, investors can mitigate any dramatic declines in any individual asset class. It’s also worth noting that equities tend to recovery over the long-term given inflation and economic growth, while commodities are valued purely on supply and demand. This means that equities may be deserving of a larger share of a portfolio.
When it comes to geopolitical risks in any single country, an internationally diversified portfolio can reduce the correlation between assets. A crisis affecting Latin American markets, for example, probably wouldn’t impact Indian equities to a large extent. Using ETFs, investors can build this level of diversification into their portfolios with relative ease.
Key Takeaway Points
- Geopolitical risks are a constantly evolving risk for international investors and many of these risks could be particularly acute in 2016.
- The impact of geopolitical conflicts on certain asset classes varies depending on the countries involved and the perceived global risk.
- Diversification is the strongest defense against geopolitical risks, since losses in one asset class are at least partially absorbed by gains in another.