Geopolitical risk has always been an important investment concern. The question today is not whether these risks are a force for volatility, but whether that force is relevant for portfolio decisions.
In some cases, the answer is an unambiguous yes. Agile, risk-tolerant portfolios can take advantage of shifts — temporary or structural — brought on by geopolitical risk. By monitoring dislocations and applying geopolitical risk analysis, one can cushion the blow of adverse events and enhance upside growth potential, generating alpha.
Geopolitical risk can also play an important role in asset allocation decisions.
Here are some insights from Lauren Goodwin, economist and strategist for New York Life Investments’ Multi-Asset Solutions team. While the original post focused on geo-political risks, these few selected insights are valuable for all of equity investing.
- After the if comes the how.
Once you have decided whether to incorporate geopolitical risk awareness into your process, focus on how you do that. Your approach doesn’t have to be complicated, but it must be structured and consistent.
Differentiate “must-have” from “nice-to-have” analysis. Consider your internal strengths and lean on external research inputs where you do not have comparative advantage.
- More headlines do not always mean more risk.
Prioritize your risks using clear criteria. Best practice suggests assessing at least “likelihood” and “impact.” The more likely and meaningful a risk, the more bandwidth it deserves. Actionability is an important consideration as well: Can you do anything if the risk turns into reality?
- Developing scenarios can help focus your process.
Geopolitical risks seldom evolve in a linear fashion, making them difficult to monitor and assess. Scenario planning can help mitigate risks, capture opportunities, and otherwise strengthen your risk management process. Scenarios can take the form of qualitative analysis, quantitative measurement, or both. A simple framework for qualitative scenario building begins with a base-case assessment of the most likely outcome. From there, you can consider alternative futures, with a focus on what constitutes a change in key risks.
- Signposts are useful metrics to track how your top risks may develop.
How can you tell if risk is rising or falling? Then what? Good signposts are based on the assumptions you’ve made upfront about the scenario and help determine whether a risk is materializing. Consider qualitative signposts like events or statements as well as quantitative ones based on financial or economic data. Share them across your team. If a signpost is triggered, have your team determine what it means for your portfolio. If signposts are quantified and automated, ensure your traders know the next steps.
- Focus on policy, not politics.
Identifying the right signposts takes some trial and error. One way to separate signal from noise is to distinguish politics from policy. Political developments can indicate changes in the risk’s likelihood or speed of evolution, but analysts can be knocked off course by following politics too closely. Focus on real economic or business outcomes.
- Mitigate risks, capitalize on opportunities.
An effective approach illuminates risks and opportunities amid uncertainty, but process can only take you so far. When the time comes, you must act on the intelligence you have.
Taken from Geopolitical Risk in Portfolio Management