Impact of Geopolitical Risk on Investment

Notably, economic expansion, interest rates, and market volatility are all impacted by geopolitical risk in the capital markets. Geopolitical risk can dictate the suitability of a security or investment strategy for an investor’s objectives, level of risk tolerance, and time horizon.

Further, it is worth appreciating that the expected return on an asset class might either increase or decrease depending on the likelihood of geopolitical risk. In other words, geopolitical risk is consequential to how appealing an asset class is for an investment plan.

The degree to which investors consider geopolitical risk when making decisions will significantly depend on their investment goals and risk appetite. While certain investors may welcome geopolitical risk, it may also be shunned by others in their decision-making process.

Types of Geopolitical Risks

The primary three types of geopolitical risk include:

1. Event RiskEvent risk is based on predetermined dates, such as elections, the enactment of new laws, or other date-based events, such as festivals or political anniversaries. Investor expectations frequently shift as a result of political events. Political timelines are a common starting point for risk analysts when evaluating event risk.
2. Exogenous RiskExogenous risk is an abrupt or unplanned concern that affects a nation’s willingness to cooperate and non-state actors’ capacity to go internationally. Unexpected revolutions, invasions, or the aftermath of natural calamities are a few examples.
3. Thematic RisksThematic risk is a risk that concerns are well-known, and they change and grow with time. Examples include the persistent danger of terrorism, climate change, migratory patterns, the emergence of populist movements, and cyber threats.

Evaluating Geopolitical Threats

In the financial environment, geopolitical risk is constantly present and has various effects on assets. An investor evaluates geopolitical risk within the following three categories:

1. Likelihood It will OccurThe likelihood of the occurrence of risk is the possibility that it will materialize. The procedure of measuring probability is, however, difficult.More collaborative and globalized nations are generally less likely to incur geopolitical risk due to the increased political, economic, and financial costs associated.Additionally, internal political stability, economic need, and governmental actors’ incentives all contribute significantly to the likelihood of disruptive action.
2. Velocity (Speed) of its ImpactThis is the rate at which geopolitical risk affects an investor’s portfolio. Volatility may, in the short term, have an impact on the entire market. Exogenous or “black swan” events will likely fall under this classification. An unusual, unpredictable incident that has a significant impact is known as a “black swan risk.”An example of such an incident is a world war. Risks that have a medium-term impact may start to affect business operations, expenses, and investment prospects, resulting in reduced valuations. They often target particular industries and affect some businesses more than others.Long-term risks might significantly affect the environment, society, government, and other areas. The immediate effect on portfolios is likely to be less significant. Noting that various risks affect investments in more than one way is important.
3. Size and Nature of that ImpactThe effects of risk on investor portfolios might take many different forms. When evaluating the significance of a risk to the investing process, investors should consider the magnitude of the risk’s impact. At the same time, a low-impact risk would not require as much analysis of its reasons and drives a high-impact risk call for attention.The nature of the impact might be discrete or broad. A discrete impact is one that only affects one business or industry at a time. A broad impact, on the other hand, affects an entire industry, a nation, or the whole global economy.Investors should consider all three geopolitical risk factors—likelihood, velocity, size, and nature of impact—when evaluating geopolitical risk for portfolio management.

   For instance, a risk that is extremely probable but has minimal effect on a portfolio may not warrant in-depth research and investor attention.

Impact of Geopolitical Risk

The effect of risks on investment portfolios can present itself in numerous ways. As such, it’s essential for investors to evaluate the magnitude of a risk’s influence when determining its relevance in the investment process. In this vein, a high-impact risk warrant extensive study, while those with minimal effects might be sidelined. Additionally, external elements can amplify a risk’s influence, especially in markets undergoing recession or downturns.

The impact of geopolitical risks can be classified as discrete (impacting a specific company or sector) or broad (affecting larger sectors, countries, or the global market).

In managing portfolios with geopolitical risks in mind, investors should collectively consider all three geopolitical risk factors (likelihood, velocity, and size and nature of impact). A risk that’s very probable but has minor implications might not require detailed scrutiny. Conversely, a risk with substantial consequences but a low occurrence chance might necessitate response planning without constant oversight.

Scenario Analysis

Scenario analysis analyzes portfolio performance across various situations or global states. A team’s commitment to its priorities and reaction can be strengthened through scenario analysis.

Scenario analysis might be a qualitative analysis, quantitative measurement, or a combination of the two.
Creating a base case for an event is the first step in qualitative scenario development. Investors can then think about both positive and negative possibilities from there to create best-case and worst-case scenarios.

The complexity of quantitative scenarios might vary greatly. A stylized scenario is a type of simple quantitative scenario in which a portfolio’s sensitivity is evaluated in relation to one important aspect that is significant to it. Such an aspect could be interest rates, asset prices, or exchange rates.

Scenario construction is a great technique for tracking risks and determining the portfolio measures that may be worthwhile since it can encourage investors to change their risk prioritizing.

Asset managers create procedures that provide quick corrections in order to strengthen a portfolio’s resistance to unforeseen change. The process of detecting warning signs for proper risk management is crucial.

A signpost is an indicator, a piece of data, or an event suggesting that risk increases or decreases in likelihood. The ability to recognize signposts should enable a team to distinguish between signal and noise and respond when signposts indicate increased risk. It might be difficult to find the correct signposts without some trial and error.

Certain combinations of economic and financial market conditions can act as clear indicators of impending trouble. Political turmoil, for instance, may be indicated by elevated inflation and declining employment.

Tracking Risks Using Signposts

To enhance a portfolio’s ability to withstand unforeseen shifts, asset managers establish early procedures that facilitate swift adjustments so that investors can mitigate the effects of these events on their investment results.

One of the procedures is to identify signposts. A signpost is an indicator, market level, data piece, or event that signals a risk is becoming more or less likely. A signpost is analogous of a traffic light.

If both quantitative and qualitative data indicate that a risk is minimal in terms of likelihood, velocity, or impact, then the signposts display a green signal, implying no immediate action is necessary. However, suppose the signposts turn amber, suggesting a moderate level of risk in terms of likelihood, speed, or impact. In that case, exercising increased caution and readiness for that specific risk might be prudent.

If a risk increases in terms of likelihood, velocity, or impact (turns red), it might be essential to formulate a response strategy.

Recognizing signposts should enable a team to distinguish between important signals and irrelevant noise and act when the signposts turn red. Moreover, recognizing the appropriate signposts can involve trial and error. A simple guideline for differentiating between signal and noise is distinguishing between politics and policy.

Certain economic and financial market conditions act as potent signposts of looming challenges. Specifically, high inflation combined with worsening employment might signify impending political turmoil.

Manifestations of Geopolitical Risk

Geopolitical risk, with its multiple forms, has a similarly varied effect on investor portfolios. High-velocity risks tend to be reflected in market volatility through immediate changes in asset prices such as commodities, foreign exchange, stocks, and bond prices.

Low-velocity risk can lead to extended effects on investor considerations. Persistent disturbances can cause reduced income, escalated expenses, or a combination of both, potentially diminishing a company’s worth. For instance, over the course of the COVID-19 pandemic, risk asset valuation recovered, but there were disturbances in movement, and consumption continued to influence company earnings and supply chains for an extended period.

Acting on Geopolitical Risk

Assessing a risk’s likelihood, velocity, and impact might assist an investor in isolating the risks that may be the most significant.

Asset allocators may use a top-down approach and incorporate geopolitical risk in their asset allocation plans. Risks’ likelihood, velocity, and impact may impact key capital market assumptions.

Investors might consider geopolitical risk in multi-factor models at the portfolio management level. For instance, disruptive threats may be used as a binary yes-or-no factor or can impact the confidence intervals around factors associated with momentum, valuation, market sentiment, or the economic cycle.

Investing objectives, risk tolerance, and time horizon all affect how important geopolitical risk is to the process of combating geopolitical risk. Reducing exposure to geopolitical risk may be acceptable for an investor with limited risk tolerance. Even then, for an investor with a long-time horizon, a geopolitical event, like an unpredictable event, may present a purchasing opportunity.

Question

Which of the following geopolitical risks is most likely a known risk that evolves and expands over a period of time?

1. Event risk.
2. Thematic risk.
3. Exogenous risk.

The correct answer is B.

Thematic risk is a type of geopolitical risk that is known, evolves, and expands over a period of time. Examples include climate change and ongoing threats of terrorism.

A is incorrect. Event risk is a type of geopolitical risk that revolves around set dates or date-driven milestones such as elections or political anniversaries.

C is incorrect. Exogenous risk is a type of geopolitical risk. It is a sudden or unanticipated risk that impacts a country’s cooperative stance or the ability of non-state actors to globalize. Examples include invasions and sudden uprisings.