Politics and your portfolio

How to protect your nest egg in times of political turmoil

By now, you’ve likely seen the horrible impact of full-scale war on the citizens and refugees of Ukraine. You’ve likely read what foreign policy experts have to say about what the current war might mean for the future of Europe. And chances are that you’ve listened to market analysts and pundits try to guess what it all means for the global economy in the months and years to come.

No matter how engaged (or disengaged) we may be when it comes to politics, it’s a subject that will affect our portfolios from time to time. Whether it be an unexpected reversal in tax law, an ongoing trade dispute between countries or, in the most extreme case, out-and-out war, politics can upend our carefully considered investment plans and force us to reconsider the strategies and assets which we use to accomplish our long-term life goals. Even more so if you invest at least a portion of your portfolio overseas (as you should). Trying to anticipate and plan for political changes in other countries is difficult to do for foreign policy experts − and almost impossible for casual observers such as you and me.

Given the ongoing crisis in Ukraine, it seems like a good time to take a deeper look at political risk, and to try and understand how best we can mitigate it. Here’s the good news: some basic knowledge and a little common sense can go a long way toward protecting your portfolio from political risks. Let’s take a closer look at what political risk is, why it matters, and some of the practical strategies that snowbirds can implement to protect themselves (and their portfolios) from it.

Understanding political risk: three fundamental truths

First things first: what exactly is political risk, and how does it differ from other risks that investors face? At its most basic, political risk is the risk of change: the possibility that a given government (municipal, regional or national) will upset “business as usual” and force companies to do business differently than the way in which they’ve done business before.

Sometimes those changes will be intentional and legal (Ottawa imposing a one-time tax on bank profits, for example). Sometimes they will be imposed by other countries (trade tariffs between the U.S. and China). And sometimes they will be denounced by the rest of the world (Russia invading Ukraine). Either way, political change can have a profound effect on how a given business makes money. And obviously, anything that affects how a business makes money can have a significant impact on the valuation which others give to that business and, therefore, the price that investment has in your portfolio.

Any investor looking to understand political risk and its impact needs to accept three fundamental truths about it:

1. Politics are unpredictable

One of the things that makes political risk so challenging for investors is that change (whatever form it takes) is difficult to measure and predict. Unlike numbers on a balance sheet, politics is an inherently subjective topic. Often, it requires a deep knowledge of the historical background of a given country, on-the-ground contacts to provide local perspective, and a good deal of “what if?” thinking to understand the potential impact of political changes on a given business − and even then, those impacts are often only obvious in hindsight.

On top of that, governments are notoriously fickle about the changes that they impose upon the business world. Rumours may circulate for months (or even years) that a government will introduce changes to the tax code, for example. And, while many analysts, pundits and commentators will try to predict the likelihood of such change, there’s really no way to know for sure whether these will actually happen (or what investors should do about them) until such changes actually become law.

2. Political risk is often driven by investor emotion

Make no mistake: political change can have a real and lasting impact on a given business (ask anyone in Ukraine or Russia). But as much as that’s true, the real risk of political change is often more emotional than it is practical.

Think about it this way: investors often react more strongly to deviations from the status quo than do businesses. And to some extent, that’s understandable: it can be difficult to really understand the long-term impact of political change in a country when you’re watching events from halfway around the world. Investors also tend to extrapolate current political crises far into the future, and often don’t account for the ability of businesses to adapt to political change over time. As a result, stock markets can frequently overreact to political events and drive the price of politically affected stocks up or down far beyond any rational measure.

3. Political risk often creates investment opportunity

You know the old saying about how crisis and opportunity go hand in hand. That’s certainly true regarding crises brought on by political change. Even with the most acute forms of political upheaval (such as what we’re witnessing in Eastern Europe), there will be opportunities for businesses that arise out of the crisis. It takes time (often years or even decades) for such opportunities to become obvious. But make no mistake, eventually these will become clear.

Veteran investors have long known that scouring the world for such politically driven opportunities can be a very good way to make money. Such an approach is definitely not for everybody, however. It requires a strong stomach for volatility, and a willingness to spend the necessary time and effort to fully research the political and business background behind a given opportunity and, let’s face it, some snowbirds simply have better things to do. That said, if you’re a seasoned, experienced investor who’s serious about looking for off-the-beaten-track ideas, there’s no denying that emotional market reactions to political risk can often make for tremendous investment profits.

Forms of political risk

Political change is not a “one size fits all” kind of risk. Instead, it can take many different forms, depending on the political environment in the jurisdiction, the state of economic development and other factors.

It makes sense to think of political risk as a kind of sliding scale in which different kinds of change can have a different degree of impact on your portfolio. Here are some of the most common political risks which investors should keep an eye out for, presented least worrisome to most troubling:

Policy changes

This covers a whole range of government-initiated changes that can end up impacting the financial profitability of companies or entire industries. Tax changes are a fairly common example here: by changing the tax rate charged on income from certain business activities, governments can make such income more or less appealing, which obviously changes the value which investors are willing to pay for a share in such businesses. Another example would be concessions or operating licences granted to certain businesses, or the regulations and rules which govern what a business can or cannot do in a certain jurisdiction, or how much they can charge their customers. Such changes can change how much profit a business can make, which has a direct and tangible impact on the price which investors are willing to pay to own shares in that business.

This is the primary political risk in developed economies such as Canada, the United States, Japan and Western Europe. While the rule of law and respect for property ownership are well established in these countries, tax laws, environmental regulations and other business rules are subject to constant “tinkering” by various administrations which get voted in and out at fairly regular intervals.

Here’s an example that most of us will remember: the introduction of the Affordable Care Act (commonly called “Obamacare”) south of the border back in 2010 was a once-in-a-generation, government-mandated change brought upon an entire industry. The new laws and regulations had a significant impact on the valuations of most health-care companies, particularly those offering health insurance. Such policy changes didn’t suddenly make health-care companies bad investments overnight, mind you. But the changes did require investors to rethink the ability of health-care businesses to make profits, and recalculate what price they were willing to pay for the future earnings of these companies.

Direct government interference

One step up on the scale of political risk is the possibility of direct government interference in certain businesses or industries. These actions could include direct and sustained attempts by a government to change the nature of a given industry operating within a country, the direct expropriation of specific company assets, or even the nationalization of entire industries. While such actions are relatively uncommon in developed economies with a history of rule of law, they continue to be rather common in emerging markets.

This is the kind of risk that comes with investing in China − a controlled economy in which the government’s priority is not necessarily protecting the rights of property owners, but advancing the Communist party’s agenda and securing long-term political power. Over the past two years, the Chinese government has directly interfered with its banking sector, forcing it to prop up ailing government industries. It has also enforced significant new regulations regarding its high-tech companies. And it has attempted to force businesses to use an accounting standard that’s significantly different than the one used in the West. Unsurprisingly, such moves have dramatically changed the valuations given to many China-based businesses, as many former market “darlings” such as Alibaba, Tencent and JD.com have sold off sharply amid the fears of further government interference.

A more recent example is the potential seizure of Western-owned airliners by the Russian government in response to Western-imposed sanctions. At the time of writing, it’s still unclear whether Mr. Putin will follow through on his threat to expropriate such property. But even the suggestion has caused the stock price of a large number of leasing companies, travel and tourism operators, and airline manufacturers to take a dramatic hit.

Continued political instability

Business hates uncertainty. And, generally speaking, the more uncertain and politically volatile a given jurisdiction, the less sure businesses and investors can be of the economic outcome of a given investment. Consequently, the more volatile an investment made in that jurisdiction will be, and the more the price in your portfolio will fluctuate.

This is perhaps the primary risk when it comes to investing in many emerging market economies where the rule of law is still very much a work in progress. Jurisdictions with a long history of political upheaval, radical changes in government and rampant corruption obviously make it much more difficult for companies to do business. Investments made in companies that do business in such countries can be subject to severe volatility as governments change, the national economy experiences booms and busts, and government repression remains an ever-constant concern.

One notable example of such instability is Argentina. While the country is rich in resources, boasts an educated, literate workforce and is blessed with a temperate climate, it has been subject to near-constant political instability for the past 100 years with numerous coups, industry nationalizations, a war with Great Britain and near-constant economic crises. For bond investors, the possibility of government default has frequently been a worry; for equity investors, government interference or nationalization is always a consideration. This is not to say that investors can’t make money in Argentina—it’s just that politics present a persistent risk that must be clearly acknowledged before investing there.

Civil unrest and war

This is the most obvious example of political risk, and a particularly poignant one given the current war in Ukraine. With very few notable exceptions, conflict and violence are very, very bad for business. And if a country is unfortunate enough to find itself drawn into a war (or the threat of such war looms as a real possibility), then companies that do business there can be subject to rapid and dramatic swings in investment value.

By now, you’re probably well aware of how the war in Ukraine has had a direct and tangible impact on any company doing business within either Ukraine or Russia − by now, most large Western companies have completely exited their Russian businesses. It has also made many large, well-known Russian firms such as Lukoil and Sberbank largely un-investible. When will the investment environment return to “normal” in these places? Who knows?

This kind of political risk also has “spillover” effects that are sometimes not as obvious. For example, the invasion of Ukraine has affected not only the two belligerents, but also many of the economies in neighbouring countries such as Poland, Romania and Belarus. The Polish stock market has taken a big hit. Travel and tourism companies doing business in Eastern Europe are reeling. And the price of potash fertilizer − a major export of Russian ally Belarus − has soared lately, largely in response to the difficulty that Belarus will have in shipping its product to overseas markets.

How to protect your portfolio from political risk: six strategies

So now that you know about what political risk is, what concrete actions can you take to protect your portfolio from these risks? Let’s take a look at some effective strategies.

Know what you’re getting into

Remember what your grandma said about an ounce of prevention being worth a pound of cure? It works the same way with investing − the best way to solve an investment problem is to avoid it in the first place.

In the context of political risk, understanding what you may be signing up for before you actually put your money into a given country will always be the first and most effective way to manage political risk. If you invest your portfolio overseas, make it a habit to do your “political due diligence” as part of your normal research and analysis. That goes double if you’re putting your money to work in emerging markets where political risk tends to be more extreme, or in sectors of a given country’s economy that have historically been prone to political interference (mining and mineral development, for example, or oil and gas production).

Should that knowledge keep you from investing overseas? Not necessarily. But at the very least, going into the opportunity with your eyes wide open will keep your expectations realistic and will make you better able to identify potential problems before they become acute.

Keep up with what’s going on

Political risk is constantly changing and evolving. This means that your analysis of that risk should not be a one-time activity which only takes place when you purchase a particular investment. Rather, you should constantly monitor your international investments (and the geographic markets in which they operate) for potential political risks.

How do you do that? Well, your regular newspaper is a good place to start for a general overview on what’s going on in different regions of the world. Weekly newsmagazines such as The Economist can provide you with a much more thorough understanding of the current political and socio-economic events in specific countries. Financial newspapers such as Barron’s offer an investment-related angle on such stories, with professional-level reporting on the potential impacts which political change can make on businesses and industries. Neither of these are what you’d call “light reading” but, if you’re really looking to understand how a different part of the world works and invests, they’re the go-to publications.

Is such constant review necessary for the average snowbirds who limit their international investing to a handful of well-diversified, professionally managed mutual funds or ETFs? Probably not. But if you’re a stock picker who singles out specific companies for investment, or you’ve made oversized bets on any one market or geographic region, then yes, it’s a good idea to keep abreast of what’s going on, so that you can get advance warning on any trouble brewing that might affect your portfolio.

Diversify, diversify, diversify

If you’re a regular reader of this column, you’ve heard us discuss the importance of diversification before. Simply put, diversification is an important principle of investing − a simple strategy that can prevent many portfolio problems before they begin. But it is utterly critical when it comes to managing political risk.

How much diversification is appropriate? As we’ve said before, that largely depends on your personal goals and tolerance for volatility. But, in general, if you’re concerned about political risk, keep your portfolio focused on jurisdictions with a strong rule of law. Those with greater risk tolerance can spread their portfolio among developing nations in Asia and Eastern Europe. If you’re comfortable with volatility, you can diversify further and invest in so-called “frontier” markets in Africa, Latin America and Southeast Asia. But keep such investments as a smaller portion of your overall pie.

Such diversification cannot eliminate political risk altogether. But by spreading your investments among many countries, and among multiple asset types, you can limit the effect of policy change, government interference, and conflict in any one country (or region) on your portfolio. Even the pros follow this strategy. Which means that you should, too.

Avoid the “too hard” pile

The world’s greatest investor − Warren Buffett − has a name for investments that are too complicated, too convoluted, or too uncertain to evaluate with any degree of confidence: the “too hard pile.” The phrase was coined by Buffett’s partner Charlie Munger to describe companies that may very well make good investments, but fall outside of Buffett’s or Munger’s circle of competence. Because these investments take far too much time and effort to truly figure out, they’re passed over in favour of simpler, more certain ideas.

You can think of certain countries (or market regions) much the same way. Unfortunately, some places in the world have long histories of political strife and instability. Given enough time and knowledge, you might very well be able to understand the opportunities that might remain hidden to many other investors. But if you don’t, it’s probably not worth the effort. Put them in the “too hard pile” and focus instead on opportunities that are easier to identify, easier to invest in and make it easier to sleep at night.

Don’t get us wrong: putting a country in the “too hard pile” isn’t to say that you can’t make money there. But such opportunities require a significant investment of time and effort before you can invest your money. Many snowbirds simply have better things to do in life.

Invest in big, multinational companies

One of the best ways to manage political risk is to let large, multinational corporations do your international investing for you. Such companies do business around the world, and are globally known for their strong brands − think Coca-Cola, Nike, Johnson & Johnson, HSBC Bank and similar names. Such investments are the foundation of any well-constructed snowbird portfolio: they’re stable, well-established businesses with strong franchises and solid balance sheets. Most of them have long track records of paying dividends to shareholders as well − exactly what the doctor ordered for most snowbirds.

Such companies also offer a degree of protection against political risk. Not only do they offer a level of “built-in” diversification (their business is literally spread across multiple jurisdictions in multiple parts of the world), they tend to be very adept at navigating the business difficulties and challenges that arise from political change. Most of them have been doing so for many, many years.

Are such companies “immune” to political risk? Well, no. Their lines of business can (and do) get caught up in the political changes in various countries around the world. But because they do business in so many places, such risks don’t typically have a catastrophic effect on the business, even if they have to write off the entirety of their investments in a given country (as many will likely do with their Russian operations). If you’re particularly concerned with political risk, it can be a good strategy to limit the international component of your portfolio to only these kinds of “best of the best” types of companies, and leave direct investment to others.

Keep an eye out for opportunities

There’s a famous saying in the investment world: the best time to invest is when there’s “blood in the streets.” This quotation is generally attributed to Baron Nathan Rothschild, a British financier who made a tremendous fortune by putting his money to work following the Napoleonic Wars. While the Baron was speaking literally, the general idea is well-suited to a whole range of political risks. Often, the best time to put money to work is when political risk seems extreme and everyone else wants to sell.

So, while you’re watching the nightly news and fretting about how geopolitical risks will impact your investment portfolio, keep the Baron’s words of wisdom in mind, and do what the “smart money” is almost certainly doing: taking a long, hard look at the opportunities that arise from political risk, and plotting their next money-making move.

A final word on political risk

Troubled by political changes in a given region of the world? Worried about how your investment in company XYZ will be affected by proposed tax changes? Unsure about how long civil unrest will last in a given corner of the world, and what that might mean for your portfolio? If you find yourself losing sleep about such questions, perhaps the best thing to do is reduce your exposure to such investments, or exit them altogether.

Will your portfolio “suffer” if you fail to include such international investments in your portfolio? Well, maybe. Or maybe not. Most experts agree that adding international diversification to a portfolio focused mostly in Canada and the U.S. is a good thing, in terms of both reducing risk and boosting your returns. But it’s hard to be certain just how much of a difference it will make.

One thing of which you can be sure, however: worrying about your portfolio comes at a price. Life is simply too short to sit up at night worried about an investment that you made on the other side of the world. Your ability to get on with your life and have peace of mind when it comes to your portfolio is very likely worth a whole lot more than an extra point or two of performance on your annual investment statement.

by James Dolan