Financial markets were sensitive to political risk early in 2017, given the U.S. health care reform uncertainty, tax reform proposals that are slow to develop, a U.S. bombing raid in Syria and North Korean nuclear tests.
While those risks seem “more sanguine” at midyear, Wells Fargo Investment Institute examines political risk and portfolios in its weekly guidance from its Investment Strategy Committee.
The report defines political risk broadly as the uncertainty that comes from trying to predict political decisions.
Unfortunately, according to the report, trying to predict such “low-probability, high-impact events” usually encourages two, often sequential, mistakes.
First, when probabilities are low, people tend to underestimate them.
“Before the Sept. 11 attacks, the risk that someone would fly an airliner into a skyscraper seemed remote, for instance,” the report explains.
Then, once the event occurs, people tend to overestimate its likelihood of repeating.
“Thus, after Sept. 11, Americans canceled plane trips and jumped into their cars,” the report states. “There were no terrorist attacks in 2002, but the number of traffic fatalities increased.”
Instead of trying to predict events, Wells Fargo Investment Institute recommends some concrete steps that may help to blunt a portfolio’s vulnerability to political risks of any type and timing:
1. Create an Investment Plan and Stick to It
Wells Fargo believes investors should prioritize among key financial goals — capital preservation, growing principal over inflation and generating income. Investors should also take into account their time horizon to achieve their goals, which will affect their risk appetite, according to the report.
“Following a long-term investment plan based on investment goals, time horizon and risk tolerance can help reduce the temptation to make emotionally based investment decisions regarding political outcomes including selling on declines and potentially missing positive market moves,” the report states.
2. Focus on quality
Wells Fargo admits that “quality” is a subjective term. But, in the report, it considers “quality” to include investing in companies whose securities are considered liquid and whose balance sheets show no more than moderate debt. In non-investment-grade credit, the report advises exposures below long-term target levels.
3. Diversify broadly
Diversification may benefit a portfolio, whether the political risks are positive or negative, and whether these risks are domestic or foreign in nature.
For example, “international positions can support overall returns even if potential U.S. tax reform and infrastructure plans disappoint markets,” the report states.
The report also suggests real assets, such as real estate, as an option for diversification. Given their potential hedging characteristics, real assets can be beneficial especially in times of turbulent financial markets. According to the report, Wells Fargo has recommended holding above-target allocations to public real estate since January.
4. Invest for Economic Growth
Wells Fargo’s basic outlook is for U.S. and international economic improvement.
“We expect U.S. cyclical equity sectors to benefit the most from our outlook, and the rebounding global economy potentially creates a chance to take international positions toward long-term target allocations,” the report states.
Wells Fargo also suggests rebalancing periodically — taking profits and reallocating into areas with greater upside potential. This process can preserve target risk levels and promote regular “buying low and selling high,” according to the report.
Wells Fargo notes that the time to rebalance is generally while profitable positions are still outperforming.
“Although the S&P 500 Index has enjoyed an eight-year outperformance against many asset classes, and we recommend, where appropriate, that investors rebalance from equities into public real estate, and restore long-term target allocations in fixed income and international equities,” the report states.
6. Make ‘Cash’ Exposure Fit Your Overall Plan
“Investors whose cash-alternative exposure persistently limits other allocations run the risk that even today’s modest inflation will undermine their plan for meeting future spending needs,” according to the report.
Wells Fargo suggests that disciplined plans that put these allocations to work at regular intervals should foster more frequent conversations with investment professionals and reviews of new opportunities.
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