Investing internationally is one way that investors diversify and seek greater returns in their portfolios. However, when investing abroad, investors are exposed to political risk.
Political risk is the risk that the investment could be adversely affected by political changes and instability in a country. It is often a significant factor with foreign investments but also affects domestic assets as well. Emerging markets may have more threatening political risk because their political systems are generally less stable.
Political Risk Definition
Each country has its own political environment. The political risk to investments is the probability that changes in the political landscape will negatively affect the investment. This could mean changes in party leadership, military control, legislation or policy. Economic instability could also stem from unexpected changes to fiscal and monetary policy. These changes could lead to a change in investor sentiment, and sometimes can make it difficult to pull money out of the investment in some cases. Political risk can affect investments in emerging markets or in domestic investments that are reliant on foreign countries.
Impact of Political Risk to Stocks
Many companies are impacted by political risk and they aren’t just foreign stocks in emerging markets. Stock markets can go up or down depending on how heavily invested they are in a particular region that is experiencing political issues. Even domestic markets can be affected by political risk in other regions if the major companies in the market rely on goods and services from other countries where problems exist.
For example, there are U.S.-centric risks where a domestic company such as Walmart may rely heavily on a foreign supply chain such as China. This puts Walmart at political risk of what happens in China.
At the same time, an emerging market such as South Korea may be heavily affected by political risk because of its long-standing tensions with North Korea. Should North Korea make an aggressive move against the south, there could be a massive disruption in the economy and output of South Korea and stocks in South Korea could be adversely affected.
While no country is immune to political risk, emerging markets tend to have more volatility as new governments pass legislation to transition the economy but may not always take the same free-market discipline that is found in many developed markets.
Evaluating Political Risk
Evaluating political risk is not always straightforward, but there are indicators that investors can look for to suggest that political risk is significant.
- Political Instability: One indicator is political instability – a possible change in government is a massive indicator of political risk.
- Legal & regulatory constraints: Another indicator is the presence of legal and regulatory constraints. In many cases, the more the government involves itself in business, the more risk there is.
- Countries with substantial tariffs and import restrictions also suggest political risk because restrictions make it more difficult to do business with the community.
- Labor Unrest: Investors can also look for local labor dissatisfaction. If employees are not happy with the work environment, there could be strikes leading to supply issues.
Tip: Investors can implement risk management strategies such as diversification to reduce political and other risks in their portfolios.
Political Risk Management Strategies
An investor can do things to mitigate the political risk exposure in his portfolio. Before investing in any opportunity, investors should perform adequate due diligence that evaluates the political risk of an investment.
Tip: It is impossible remove all political risk from a portfolio. Investors should seek to understand the areas of biggest risk and work to manage that exposure.
By not being overexposed to a single country, investors can manage political risk. Diversification simply means not having all your investments in one or one type of investment. By doing this, you limit the impact of any one country (or region) to your portfolio.
2. Take a Cautious Stance Towards High-Risk Countries
It may be best to simply avoid investments in areas with known political unrest. Political unrest increases the chances of something happening that adversely affects investments. Places where there are wars, uprisings, or massive party shifts, are places that investors can choose to avoid.
3. Invest In Companies Adapting the Market
If big business is financing subsidiaries or making other capital investments into a region, they mitigate political risk. Not only does capital investment improve the work environment, but it also improves the quality of life for employees, helping keep the labor market stable.
4. Invest Where There Is Vertical Integration
Companies that are not reliant on one country’s political landscape are better able to withstand the effects of political strife. Look for companies that are integrated across several markets and not exclusive to one.
Political risk is a very real factor that affects investments that have a heavy foreign reliance. These may be companies reliant on foreign markets for supply chain elements or companies located directly in foreign countries. Political unrest can lead to market declines. Investors need to determine how much risk they are willing to take for higher returns in their portfolio. Investors can also implement mitigation strategies such as diversification to reduce overall risk.
This article was written by
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