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Recent articles have discussed the importance of investing overseas.
Political risk applies to both developed and undeveloped countries.
It is important to consider the political risk associated with those
investments and the effect that risk can have on your portfolio.
From an investment portfolio perspective, unexpected changes in
actions and policies taken by a country’s leaders can greatly impact
that country’s financial markets. Nowadays, the actions taken in one
country will often reverberate through other financial markets
around the world. This risk is referred to as political risk.
For instance, the press reports that a Chinese government official
raises concerns over how high and fast stock prices have risen.
Traders around the world speculate that the Chinese government may
take action to control the market. China’s stock market has a
massive sell-off, erasing 10% of its value in one day.
That speculation then reverberates through the world’s financial
markets. The major U.S. stock markets decline 3% in one day. At one
point during the day, the Dow Jones Industrial Average drops over
150 points in one minute. The average investor loses thousands,
maybe even tens of thousands of dollars in one day.
But it doesn’t stop there. The worldwide market correction causes
investors to reassess the amount of risk in their portfolios. They
are concerned and take action to reduce their exposure. So the
markets don’t just drop one day, but a down-cycle lasting weeks or
months develops.
There are many other examples that I can give. There is a coup in
Thailand, which affects foreign investors. Hugo Chavez, the
President of Venezuela, announces the government is taking control
over various industries with substantial foreign ownership. Stocks
of companies with investments in Venezuela are immediately affected.
Political changes are a risk to a portfolio, but they can also be an
opportunity. Having the foresight to anticipate political changes
and the effects it will have on a country will allow you to buy in
before everyone else does.
For instance, countries issue bonds just like companies do. The
interest rate paid on those bonds (how the bonds are priced) depends
on the financial and political stability of the country. Several
years ago, Brazil was in serious financial trouble. Its bonds paid a
very high interest rate to reflect that risk.
The government took steps to improve the financial condition. It
changed tax policies and opened markets to foreign investment. As
those policies took effect, the country became more stable. As the
risk associated with owning Brazilian bonds decreases, so does the
interest rate those bonds pay. If you purchased one of the bonds
when it was paying the high interest rate and sold it after the
country became more stable you would have made a handsome profit.
For years, most industries in China were government owned and
controlled. Foreign investment was restricted and there wasn’t a
viable means of trading stocks. In the past several years China has
made it easier for foreigners to invest. It has also been
privatizing government owned companies. That process is still in the
early stages. Although there continues to be significant risks
associated with investing in China, there are also great potential
rewards.
Remember that there is a trade-off between risk and reward. An
investor’s goal should not be to avoid all political risk. If you
do, you will have to settle for lower returns. Lower returns mean
you will have to save more to provide for retirement. Lower returns
mean that you may not get the income from your portfolio that you
need to live on during retirement.
Instead, there are two things that you need to do. First, understand
that political risk exists. Even if you only invest in U. S. stocks
and bonds, your portfolio will still be impacted by the actions of
political leaders around the world.
Second, try to identify the political risks associated with the
investments you own. The risk associated with equity investment in
emerging market economies is different than those of developed
countries. The risk associated with bond investments is different
from those of equity investments.
Third, take steps to manage that risk. Alter your investment
strategy. Broadly diversify your portfolio to reduce
country-specific risk. Utilize both stocks and bonds. And have an
exit strategy in place in case something unexpected occurs.
Nationally-syndicated financial columnist and Certified Financial
Planner® Jeffrey Voudrie provides personal, in-depth money
management services and advice to select private clients throughout
the USA. He’ll answer your financial question – FREE at
www.guardingyourwealth.com. |
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