Recent articles have discussed the importance of investing overseas. Political risk applies to both developed and undeveloped countries. It is important to consider the political risk associated with those investments and the effect that risk can have on your portfolio.
From an investment portfolio perspective, unexpected changes in actions and policies taken by a country?s leaders can greatly impact that country?s financial markets. Nowadays, the actions taken in one country will often reverberate through other financial markets around the world. This risk is referred to as political risk.
For instance, the press reports that a Chinese government official raises concerns over how high and fast stock prices have risen. Traders around the world speculate that the Chinese government may take action to control the market. China?s stock market has a massive sell-off, erasing 10% of its value in one day.
That speculation then reverberates through the world?s financial markets. The major U.S. stock markets decline 3% in one day. At one point during the day, the Dow Jones Industrial Average drops over 150 points in one minute. The average investor loses thousands, maybe even tens of thousands of dollars in one day.
But it doesn?t stop there. The worldwide market correction causes investors to reassess the amount of risk in their portfolios. They are concerned and take action to reduce their exposure. So the markets don?t just drop one day, but a down-cycle lasting weeks or months develops.
There are many other examples that I can give. There is a coup in Thailand, which affects foreign investors. Hugo Chavez, the President of Venezuela, announces the government is taking control over various industries with substantial foreign ownership. Stocks of companies with investments in Venezuela are immediately affected.
Political changes are a risk to a portfolio, but they can also be an opportunity. Having the foresight to anticipate political changes and the effects it will have on a country will allow you to buy in before everyone else does.
For instance, countries issue bonds just like companies do. The interest rate paid on those bonds (how the bonds are priced) depends on the financial and political stability of the country. Several years ago, Brazil was in serious financial trouble. Its bonds paid a very high interest rate to reflect that risk.
The government took steps to improve the financial condition. It changed tax policies and opened markets to foreign investment. As those policies took effect, the country became more stable. As the risk associated with owning Brazilian bonds decreases, so does the interest rate those bonds pay. If you purchased one of the bonds when it was paying the high interest rate and sold it after the country became more stable you would have made a handsome profit.
For years, most industries in China were government owned and controlled. Foreign investment was restricted and there wasn?t a viable means of trading stocks. In the past several years China has made it easier for foreigners to invest. It has also been privatizing government owned companies. That process is still in the early stages. Although there continues to be significant risks associated with investing in China, there are also great potential rewards.
Remember that there is a trade-off between risk and reward. An investor?s goal should not be to avoid all political risk. If you do, you will have to settle for lower returns. Lower returns mean you will have to save more to provide for retirement. Lower returns mean that you may not get the income from your portfolio that you need to live on during retirement.
Instead, there are two things that you need to do. First, understand that political risk exists. Even if you only invest in U. S. stocks and bonds, your portfolio will still be impacted by the actions of political leaders around the world.
Second, try to identify the political risks associated with the investments you own. The risk associated with equity investment in emerging market economies is different than those of developed countries. The risk associated with bond investments is different from those of equity investments.
Third, take steps to manage that risk. Alter your investment strategy. Broadly diversify your portfolio to reduce country-specific risk. Utilize both stocks and bonds. And have an exit strategy in place in case something unexpected occurs.
Source: http://www.dailyrosetta.com/investing-how-political-risk-affect-your-investments/33711.html
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