Why investors should stop second-guessing geopolitics

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Equity investors often abandon their long-term plans when geopolitical tensions create market-moving headlines, but our research shows it's time to ensure that investors follow through.

After the onset of six of the most prominent geopolitical crises since 1974, our research shows global equity investors would have recovered their losses in anything from one to 190 days. Because the recovery period is so unpredictable, investors who panic and sell on the morning of a crisis may find the markets recover much quicker than expected.

Second-guessing geopolitics is usually unprofitable.

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If a geopolitical crisis doesn't alter the fundamental argument for an asset, it may in retrospect even be a catalyst to buy, not sell. Investors may initially assume markets will take a while to recover and stay on the sidelines. Later, they may find out the recovery period was actually shorter and, in hindsight, an opportunity to get in at cheaper valuations. Even when assets bounce back, investors may lack the stomach to re-enter a market that recently saw dramatic volatility. When framed in this context, investors should see geopolitical volatility as an insufficient reason to alter strategic plans.

How to prepare

Although knee-jerk reactions to a crisis tend not to pay off, there are things investors can do to prepare.

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First, they should focus on longer-term economic and corporate dynamics. Our research shows business cycle trends can affect portfolios far more than single events. The collapse of the Soviet Union at the end of 1991 did not have as much impact on the market as the U.S.'s emergence from a recession just nine months previously. Investors should only expect a larger risk premium to creep into markets if they believe a geopolitical issue is correlated to broader set of problems, or if it is not contained.

With respect to recent events, this could come about if we believe that rising geopolitical tensions are attributable to some underlying factor that could play out elsewhere. But unlike the Arab Spring, recent bouts of political turbulence do not seem to have a clear underlying cause. Investors who try to ascribe systemic importance to these events are effectively gambling. They would be better served by focusing on broader factors, chiefly the global economic recovery, as a clearer, more ubiquitous source of returns.

Second, investors should ensure they not only diversify their portfolios, but diversify them globally. Like earthquakes, most geopolitical shocks have local epicenters that are disproportionately affected. Holding stocks in a few countries does not diversify sufficiently against risk. For instance, although worst-case scenarios over Ukraine have not materialized, Russian investors with an excessive home bias would have still fared poorly over the crisis in the country. Since February 26, when the presence of pro-Russian militia was first reported in Crimea, Russian equities have greatly underperformed other emerging market stocks.

In short, private investors are best served if they avoid shooting from the hip the morning a geopolitical crisis covers the headlines. More often than not, holding a diversified portfolio will protect them from its vagaries.

Even when unforeseen geopolitical events damage large portions of the global stock market, losses are limited and temporary, with average peak-to-trough falls of 9.1 percent. For investors, reacting to slow-moving developments in asset price valuations and business cycles may be more staid. In the long run, however, it's likely to prove more profitable.