Strategies for Mitigating Geopolitical Risk

investing

Risk is a necessary evil in every portfolio – but that’s not necessarily a bad thing. Risk is why stocks can outperform safer, conservative investments like bonds and treasuries. The key is to diversify your holdings so that one single risk doesn’t pose too much of a threat to your overall portfolio.

Many investors believe that diversification begins and ends with simply buying a number of stocks in a different industry. While that might help protect against several forms of economic and industry risk, it doesn’t do much for macroeconomic concerns like geopolitical risk. To defend against this kind of threat, investors will need to have a thorough understanding of what geopolitical risk is and how they can prepare for it.

Welcome to the geopolitical arena

Globalization is when businesses operate on a global scale and not just within a specific region or country. You might think that the term only applies to large multinational corporations, like Apple or Exxon Mobil, but it affects every business in every industry around the world.

For example, imagine a small regional hardware goods retailer that doesn’t do business outside of the state. You might think it’s immune to geopolitical risk, but then a group of protesters overthrows the government in Bangladesh. Suddenly there’s a supply chain disruption problem where the company that manufactures the hardware goods makes exporting them difficult. Now the small regional store has no choice but to buy from an alternative, more expensive supplier and is forced to increase the price, lowering their returns.

While the above scenario might be somewhat far-fetched, geopolitical risk can affect almost anything, making it hard to plan for or predict. The best way to handle it is to keep abreast of what the political risks are. If there are tensions in the middle east, oil prices are likely vulnerable. European debt crises could mean a spike in United States treasury yields and falling bond prices.

Increased volatility from geopolitical risk can be a good thing for investors. Investors that sell out of the markets, especially in a sector that isn’t affected by the event, leave the door open to value seekers who can swoop in to buy at a discount. Interestingly, history has shown that geopolitical risks don’t have a long term impact on the markets.

The best strategy for a drop in stock values due to geopolitical risk is to buy into the dip. Even sectors that are directly impacted by the event don’t stay down once the event has ran its course. Investors generally over-react to the risks, causing a larger movement in prices than is warranted. In this case, contrarian investors may be the correct ones.