Diversification against political risks is a strategic approach to protect your investments from geopolitical instability, policy changes, and other political events that can negatively affect financial markets.
Different regions respond differently to political events. For instance, while one country may experience instability due to political upheaval, another might remain stable or even benefit. Geographical diversification helps in reducing the risk that a single event can impact your entire portfolio.
How Invest in a mix of developed and emerging markets across different continents. Developed markets often offer stability and lower volatility, whereas emerging markets can offer higher growth potential. International mutual funds, global ETFs, and direct investment in foreign equities are effective tools for geographical diversification.
An optimal cap for international equity allocations in a diversified portfolio should be guided by the global market capitalization of international equities, which is currently around 40%. Including international equities can help mitigate the volatility of a U.S.-centric equity portfolio. The most substantial reduction in volatility occurs when international equities grow from 0% to 20% of the total equity exposure. Increasing the allocation further, from 20% to 35%, continues to decrease volatility, albeit at a diminished rate.50
From 1970–2013, U.S. stocks were more likely to underperform international stocks over a random 10-year window, with only a 41% success rate. This made a strong case for investing in international stocks a decade ago. However, U.S. stocks have since outperformed both international stocks and U.S. bonds. Since 1926, U.S. stocks have outperformed 5-Year U.S. Treasury Notes in 83% of all 10-year periods and nearly 99% of all 20-year periods.
When considering international equities, bear in mind that many U.S. companies already generate substantial revenue from abroad. For instance, S&P 500 companies collectively obtain 40% of their revenue outside the U.S., indicating that the S&P 500 is already internationally diversified, including exposure to emerging markets. Notably, the S&P 500 tech sector derives 58% of its revenue from outside the U.S. Consequently, adding international funds to your portfolio may result in under-weighting large tech stocks globally.
Stock buybacks — concentrated among cash-rich U.S. firms, technology especially — have amplified U.S. large-cap returns: repurchases shrink the share count and lift earnings per share without any growth in the underlying business, and some companies borrow to do it. That financial engineering cuts both ways. The corporate leverage that flatters returns in a bull market can deepen and prolong the next downturn, and a buyback-driven edge in U.S. indices need not persist. Nor does adding international reliably rescue you: global equity markets have grown highly correlated, so the diversification an ex-U.S. allocation appears to offer on paper shrinks in precisely the synchronized sell-offs where you would want it most.
Currency fluctuations can significantly impact your investment returns, especially in times of political turmoil. By diversifying across different currencies, you can hedge against the risk of any single currency weakening significantly.
How Hold investments in assets denominated in multiple currencies. This can include foreign bonds, currency futures, foreign currency savings accounts, and ETFs that track non-domestic currencies. Forex trading platforms and multi-currency accounts can also be useful for managing currency exposure.
Different asset classes react differently to political events. For example, while equities might decline during political instability, commodities or certain types of bonds might hold their value or even appreciate.
How: Include a mix of equities, bonds, real estate, commodities, and potentially alternative investments like hedge funds or private equity in different regions and currencies.REITs for real estate, commodity ETFs, international bond funds, and global asset allocation funds.
Research by the IMF and World Bank suggests that countries with high political risk experience lower investment growth. Diversification helps mitigate this risk.
Studies in Journal of Finance have demonstrated that portfolios diversified across countries and currencies tend to have lower volatility and better risk-adjusted returns than those that are more concentrated.
Diversifying your investment portfolio across different geographies and currencies is a prudent method to safeguard against political risk. By allocating capital across various regions and asset classes, you can protect and potentially increase your returns, capturing opportunities that distinct markets and currencies present.