Diversification and Discipline

Managing Geopolitical Event Risk

Geopolitical uncertainty is an ever-present source of risk for the economy and financial markets. International tensions ebb and flow – sometimes simmering down to base levels and sometimes boiling over as is currently the case in Ukraine. In this article, we will take a closer look at how financial markets have responded to the events in Eastern Europe and illustrate how basic principles like diversification and discipline have helped protect our clients’ wealth in the face of uncertainty.

How does today’s uncertain geopolitical environment compare to other tumultuous periods? The Caldara and Lacoviello Geopolitical Risk (GPR) index quantifies risk based on the percentage of published articles related to adverse geopolitical events. A measure of 100 represents a normal or baseline reading. Readings above 100 indicate higher risk levels and readings below 100 indicate relatively lower risk. The index spiked higher in conjunction with the Gulf War, after 9/11, and most recently with Russia’s invasion of Ukraine.

Impact on markets

Investors price assets based on their expectations for future cash flows, growth, inflation and discount rates. The onset of significant geopolitical risk widens out the potential future outcomes. It becomes more difficult to value assets based on a short-term outlook when possible future states range all the way from WWIII to peace. As a result, asset prices become more volatile. We have seen evidence of this across a wide variety of asset classes, but particularly in bonds & commodities.

After the initial shockwaves associated with the pandemic, we enjoyed a period of below average volatility until late 2021. Entering 2022, there were plenty of unanswered questions with regard to new COVID variants, supply chain constraints, inflation levels, and monetary and fiscal policy expectations. In addition, tensions were escalating in Eastern Europe as Russia began posturing for an invasion of Ukraine which occurred in late February and continues today. Below, we highlight asset class returns for calendar year 2021, pre-invasion 2022 (12/31/2021–02/23/2022), and post invasion 2022 (02/24/2022–03/22/2022).

Managing Wealth In Volatile Markets

During periods of increased volatility, there are basically two approaches an investor can take to manage assets. One approach, the one that often looks the most attractive in hindsight, is to anticipate events and resulting short term asset class movements in advance. The investor would take concentrated positions in assets that are primed to appreciate and exit (or even short) positions that are primed to decline in value. While it sounds simple enough, this approach is actually fraught with challenges that make it exceedingly difficult to implement effectively.

For starters, effective implementation of this strategy assumes the investor 1) can accurately predict specific future events as well as their timing and 2) knows how the markets will respond to those events. As an example, this would mean knowing (in advance) that following a period of failed diplomatic reconciliation, Russia would invade Ukraine on February 24, arguably increasing the odds of a broader global conflict, AND foresee that domestic stocks would appreciate by more than 5% in the month that followed. Consider:

What if Russia didn’t invade?

What if they didn’t invade on February 24?

What if peace broke out on February 25?

What if some unrelated event completely usurped the market impact of a Russian invasion?

What if stocks declined following the event instead of the opposite?

With the benefit of hindsight, it’s easy to convince ourselves that all of these questions had obvious and predictable answers. This simply isn’t the case if we’re being honest, and the downside risk of being wrong under this approach is significant.

What if we could predict anomalistic events like the onset of war in Ukraine? In a way, we can. The world is predictably unpredictable. If we look out over the next ten or twenty years, we can virtually guarantee a few things. We can’t guarantee an invasion on February 24, but we can pretty much guarantee we will encounter recessions, temporary market drawdowns, geopolitical issues and even the occasional pandemic. We won’t always know what is coming, but if we know that certain types of events are pretty much guaranteed to happen, we can construct client portfolios with that knowledge in mind.

This approach, which aligns with our investment philosophy, calls for constructing a properly diversified portfolio, developing a long-term investment plan in advance, and sticking to it when one of these predictably unpredictable events occurs. Diversification across and within asset classes reduces unsystematic risk. It eliminates the possibility of owning an entire portfolio of Russian stocks before their values plummet. In fairness, it also eliminates the possibility of owning an entire portfolio of commodities which have spiked higher for the same reasons. Given the challenges with predicting specific events and the market’s short-term response, it’s a trade-off we believe will pay off for our clients.

While we may not know how a specific asset class will perform in a given month or even a year, we have a better sense for longer-term risk and return characteristics. We use this knowledge to construct the diversified portfolios that underpin clients’ financial plans, balancing return requirements with their ability and willingness to take risk.

An allocation to equities will support long-term growth if we maintain discipline in uncertain times. We believe short-term market-timing strategies are unlikely to improve long-term outcomes. Stocks have outperformed cash in 60% of one month periods and 72% of 12 month periods dating back to 1933. Attempting to avoid a down month or a down year risks missing out on periods of growth and potentially impairing long-term portfolio returns. The better approach, we believe, is to own diversifying assets like bonds and alternatives so that a down market in equities will not derail your long-term plans.

Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. Investment decisions are made in alignment with our documented investment philosophy and always with the intention of serving our clients’ best interests. Please contact any member of our team if you have questions.