How to Prepare Your Portfolio for Geopolitical Turmoil

Egyptian opposition protesters chant during a demonstration in Tahrir Square as part of the 'Tamarod' campaign in Cairo, Egypt.
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Egyptian opposition protesters chant during a demonstration in Tahrir Square as part of the 'Tamarod' campaign in Cairo, Egypt.

Had anyone asked back in January what kind of risks you thought might be giving financial markets a jolt by mid-year, odds are that you would have talked about the Federal Reserve's intentions with respect to quantitative easing, the outlook for economic growth and whether S&P 500 companies are delivering the kind of earnings that analysts had been expecting.

Perhaps, given recent history, you might have thrown out an additional concern: That some unforeseen event in Spain or Italy might buffet the Eurozone and spill over into North American markets—after all, that has become an almost routine summertime occurrence.

A military ouster of Egypt's government probably wouldn't have been high on your list.

That is the problem with geopolitical events, in a nutshell. They tend to fall into the category that former Defense Secretary Donald Rumsfeld famously referred to as "unknown unknowns": They can't be predicted.

But they can roil markets and leave unwary investors with large losses. The key to surviving geopolitical market turmoil is to understand the different forms it can take, and, when possible, take action to limit your exposure and your risk.

When you know there could be a problem

This is the kind of situation confronting investors with the European fiscal crisis, now in its third year.

Clearly, the nations on the periphery of the Eurozone continue to grapple with intractable problems: heavy national debt loads, astonishing unemployment levels (as many as half of all those under 25 in some nations are jobless), the prospect of a banking sector meltdown and all the political turmoil associated with that.

Nor is it as if we can take refuge in the "healthier" economies in Europe, as the problems on the periphery are taking a toll on countries like France, Germany and the Netherlands.

It's in that context that Portugal has just delivered an electric shock to financial markets in Europe, in the wake of the resignation of the country's finance minister on Monday and more resignations likely to follow, putting in question the fate of Portugal's coalition government.

That could trigger a nasty chain of events, with questions about the Portugal's ability to deliver the fiscal reforms it promised as part of its financial bailout.

Can you anticipate this kind of geopolitical tension?

Sure. Ever since the Greek crisis raised its head, economists and market analysts have been scrutinizing the fiscal positions of European nations, even as their financial markets have sold off.

By now, there are myriad ways to approach this: limiting exposure to volatile nations, while investing mostly in companies whose fate isn't tied to what happens in the Eurozone.

Above all, it's a matter of steering clear of Eurozone banks, whose fate remains unclear as policymakers try to devise a long-term solution to the problem.

When there's a problem that may or may not affect financial markets

In many ways, this is the toughest category to contemplate. We know that there is a horrific civil war underway in Syria, for instance, and that there are geopolitical tensions between North Korea and Japan.

But neither Syria nor North Korea has ever been an investible market, and no one investing in Japanese stocks or bonds would seriously consider not doing so because of the remote chance that the war of words (and the occasional harmless North Korean missile) will suddenly turn into a real shooting war.

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But these kinds of conflicts can affect markets in different ways. In the Middle East, regional alliances are an issue. The Syrian conflict is an example of that, with great powers like Russia and Iran having a kind of "proxy" interest in the outcome.

There really isn't much you can do, other than monitor developments and be aware that saber-rattling may increase volatility in the market. Some options might include using options on volatility to manage that risk, or being prepared to turn to safe haven investments should the headlines get truly ugly, at least temporarily.

When you realize with hindsight that you might have expected this to become a big problem

This is the category to which recent events in Egypt belong. Looking back, Egypt has been anything but stable since the events of the Arab spring that unseated long-time president and strongman Hosni Mubarak in 2011.

It isn't just in Egypt that recent political events have overwhelmed daily life: In Brazil, protests over proposed public transportation fare hikes have evolved into protests against the country's governing elite.

Again, with 20/20 hindsight, this could have been anticipated. Inflation is running amok, Brazil's employment picture is deteriorating. The odds were high that some catalyst would lead to this kind of widespread rioting.

Similar catalysts existed in Indonesia (the removal of a fuel subsidy) and Turkey (the proposed paving over of an Istanbul park as part of a real estate development project).

This is where asset allocation becomes important. Anyone who had taken a hard look at what was happening in some of these countries could have noticed that there was a risk that something would flare up, even if they couldn't say precisely what it would be.

Any investor who began the year by deciding to underweight emerging markets – acknowledging the probability that China's growth would remain slow relative to recent history and that other problems might curb market performance in other segments of the asset class.

If there are any clouds on the horizon, and you can't tolerate volatility or the prospect of big paper losses, it's time to hedge your exposure to a sector or reduce its weight in your portfolio in favor of something safer.

And yes, that means that you have to ask yourself these questions today about other parts of the world, such as Russia and India. Are there factors there that might trigger similar geopolitical upheavals?

When something happens out of the blue

Some geopolitical events you simply can't anticipate at all, and it would be unwise to try to plan around. The terrorist attacks of 9/11 fall into that category.

They provoked a massive market selloff and contributed to recession that followed, but no investor in his or her right mind should have spent the months leading up to September 2011 keeping half their portfolio in cash just in case such an improbable event occurred.

We need to be realistic about the kind of events that can be anticipated – political instability in Egypt – and those that only appear logical with hindsight. Expecting anyone to anticipate a terrorist attack, a political assassination or anything of that ilk is foolish; by that logic, we should never leave our homes because of the risk of being hit by a car as we cross the street.

There is one peculiarity of geopolitical events that you need to remember in assessing their actual or potential impact on financial markets: You need to understand the extent to which, even though they appear to be confined to one country, they have a much wider influence.

Egypt is a great example. If political instability causes the Suez Canal to be shut down, it would disrupt global trade to a tremendous degree. In contrast, what is happening in Brazil will definitely take an additional toll on that country's already struggling economy, but except insofar as it reflects a global trend about protests linked to increased inequality, disturbances there won't spill over automatically into Argentina, say.

In normal market environments you may not need an advanced degree in political science to figure out the risk and return profile of your portfolio.

But these aren't normal market environments any more. Increasingly, we rely on global markets for a hefty chunk of our investment returns and being attuned to geopolitical risks is just part of the price we must be prepared to pay.

By Suzanne McGee, The Fiscal Times