The past 18 months have been particularly unsettling for individual investors, who have witnessed a crumbling of both their net worth and the underlying assumptions that drive their investment decisions.
The US equity market, a benefactor of the “home field bias” that pervades the investment analysis conducted by many individual investors in the US, has corrected to levels seen a decade ago.
Real estate, previously considered the most reliable asset class by average Americans, has taken a well publicized beating, exposing the flaws in the two step investment strategy of lever an asset and hold.
The bond market too, has not been kind to retail investors, a fact that the individuals who held $6B worth of GM (GMGMQ.PK) debt can certainly attest to. To make matters worse, the Lehman (OTC:LEHMQ) bankruptcy triggered losses at a money market fund that caused it to “break the buck”, calling into question (at least at the time) the safety of any investment vehicle.
Thankfully, the period of time during which the financial system literally seemed on the precipice of collapse has passed. Unfortunately however, in the wake of the post-Lehman turbulence, a new sort of risk has emerged in the investment landscape: political risk.
Although formal assessments of political risk have been conducted for many years- spawning an entire subset of professional consultancy-its relevancy has largely been confined to corporations and institutions.
In the context of present day investment decisions however, we would argue that an individual investor’s ability to properly identify and assess the relevant political risks to his/her wealth preservation/creation is more important now than at any time in recent history.
To achieve this task, individuals will need to develop a cogent framework with which to approach an issue of political risk; they will also need to perform some minor revisions to the way they view the world.
Although we certainly don’t have all the answers, we have sketched an outline, organized along subcategories of what we perceive to be the top three facets of political risk as they exist today.
For the sake of this discussion, political risk will encompass all risks stemming from official government actions, regardless of whether the action is overtly “political” in nature.
Capital Structure Risk
Until recently, investors thought they knew the rules governing relative positions of priority in the event of a bankruptcy. Then came the Chrysler and GM bankruptcies.
Without spending time on the specific criticisms we have as to the handling of those bankruptcies, we would emphasize the fact that “too big to fail” should no longer be misconstrued as “too big for you to lose your investment”. Government rescues have certainly not boded well for both equity and unsecured debt investors-the two areas of the capital structure most accessible to retail investors.
If you intend to invest in these two intervention-prone areas, it is more important now than ever to fully educate yourself as to which stakeholders are in front of-and behind-you in the event of a bankruptcy proceeding. Some would conclude that a prudent course of action may be to avoid investing alongside union interests; a group that wields considerable influence in the upper echelons of government (especially during a Democratic Administration).
As a personal recommendation, we’ve found it never hurts to follow the money - OpenSecrets.org is a great place to do this.
Reserve Currency Risk
With the United State’s influence in a period of relative decline, albeit at an arguable pace, individuals need to consider whether it is prudent to hold assets denominated entirely in dollars. The US Government’s agglomeration of debt has provoked a series of reactions from the Chinese and other major holders of dollar based reserves.
Once again, there is no way to predict the future of the dollar-or anything else for that matter-however , it is important that retail investors begin paying closer attention to the words and actions of foreign governments and central banks. Press releases and other news relating to major foreign governments/central banks can, for the most part, be monitored via RSS feed.
As the actions of foreign governments become increasingly relevant to the performance of “US based” assets, retail investors should adjust their awareness and exposure to emerging markets in commensurate fashion.
Market Distortion Risk
The United States government, currently the largest investor on the block, has the ability to severely distort any market which it enters. For individual investors, this dynamic is currently most pertinent to investments in US Treasury debt; the market for which is currently the site of heavy Fed purchases. All investors must now be astutely aware of all current and planned Government securities purchases. News from both Treasury and the Federal Reserve can easily be tracked via RSS feed.
The best thing an individual investor can do is to educate him/her as to every major government rescue program, and in the event that he/she is invested alongside Uncle Sam, simply apply some common sense to the situation.
The current state of the global economy has produced a set of political risks that we will readily admit, are more complex than an article of this length has the ability to convey. It is likely that entire academic departments will be formed around this concept in the future, and will of course produce insights that put ours to shame.
Ultimately though, we think that the best course of action for individual investors is to simply position themselves in front of the news that is most relevant to the three areas described above, and apply what is truly the only necessary ingredient to a sound investment strategy: common sense.
Disclosure: no positions