Rethinking political risk

In recent conversations with investors about the prospects for global growth, the focus seemed to be more on the upcoming US election and Brexit than on economic fundamentals. It struck me how musings on political risk can influence an investor’s view on long-term market returns.

Is it appropriate to consider political risk when formulating investment strategy? The investment community is probably split on this issue. 

But I worry that those who do consider how politics affect their investment decisions are confused. Political risk can be defined as the probability that political activity will disrupt business outcomes. That raises the question: what kind of political activity? 

The concept of political risk is often applied to emerging market countries, where property rights may not be properly protected. In reality, I struggle to see where political risk is low today. At the same time, political risk is difficult to estimate and build into investment frameworks in a sensible way. For these reasons, most investors tend to consider political risk only partially and inefficiently. Most believe, to a degree, in the efficient-market hypothesis – to the extent that prices fully reflect available information, markets will indicate how a political event might affect investments.

Some investors go as far as making a call on the outcome of a specific political event, which is perceived to be relevant, and position their portfolio accordingly. Is that sensible? Perhaps it is better to forget about political risk altogether, or rethink it completely. 

A better approach would be to focus on how a country’s politics can accommodate long-term economic growth. Investors should base their decision to invest in a country on whether the fundamental structures that allow enterprises to flourish are likely to hold. That seems beside the point of short-term political risk analysis. 

A different question altogether is whether investors are taking political matters into their hands by making investment decisions on which sectors or countries should be backed or banned. On that issue, I see less of a problem. While institutional investors’ direct participation in politics is undue, that does not mean they should invest as if they were in a bubble. Ultimately, by focusing on investments that are good for their beneficiaries, they are, in theory, helping the advancement of society as a whole (and vice versa). 

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