Geopolitical risk is a challenging subject for investors, owing to its nebulous, complex and episodic nature. With little in the way of rigorous research, investment management can end up being informed by little more than instinct or anecdote. This is of heightened relevance today in a climate of intensifying geopolitical risk. All over the world, in developed and emerging markets alike, it feels like there is nowhere to hide.
One perennial investing question associated with geopolitics is how to respond to shocks, the proverbial "bolts from the blue." My firm has conducted empirical analysis of local market reactions to surprise events such as coups, assassinations, civil disruptions and natural disasters. Even for high-impact events that initially trigger material losses, we see neither evidence of continued declines over the two weeks after the occurrence nor compelling evidence of substantial reversion. In other words, the results don't suggest cutting losses or doubling down on positions following such shocks, absent an informed view on the specific circumstances.
Without compelling evidence to support a reflexive response to geopolitical events, we advocate resisting the temptation to intervene. In the heat of the moment, such decisions are likely to be based on partial and inconsistent information. Pressured decisions in the immediate aftermath of an event risk perceptual and judgmental errors, especially given the emotional charge implicit in the term "shock."
But this doesn't mean do nothing; it means be proactive. Implement a sound, systematic process as ex-ante preparation. Take a "high breadth" approach to active international investing, to contain the impact from idiosyncratic geopolitical events, and prudently size country, sector and stock-level positions. After-the-fact responses to sudden shifts in conditions may disrupt alpha capture, create churn and costs, and render portfolio behavior difficult to understand.
However, in specific contexts, intervention might be justified — if, for example, an investor has access to material event-specific information. Other valid motivations might include circumstances in which the total risk associated with a foreseeable event exceeds tolerance levels, or where there is potential confusion between alpha and an appropriate market response to a specific stimulus. Even then, however, the intervention should reflect a measured and deliberate trade-off between risk reduction vs. alpha and costs. This underscores the value of a quantitative approach to portfolio construction and implementation.