RISK is a term that has a strong role to play in your investments. Warren Buffet aptly defined risks as 'not knowing what you are doing'. To make life simpler for investors and traders, experts came out with a range of numbers within which a risk is worth taking. Some look at risk-reward ratios to decide on their investment decisions. However, there is one set of risks that is not quantifiable.
Geopolitical risk is one such key element that investors are always exposed to. Epidemics and natural calamities such as earthquakes and floods can mar the fortunes of a country. This can adversely affect the economic growth of the nation and, in turn, hurt investors. In case of dry spells or heavy rains, an economy such as India, receives lower agricultural output and a large consumer base loses out on the purchasing power front. This impacts production numbers across industries and drags the stock prices down. Countries which are not in a position to meet their foreign obligation also pose a serious risk. A war between two countries or a civil war within a country, such as the one fought in Sri Lanka for decades, also impacts an economy as a whole. With rising integration of global economy, geopolitical risks are important.
Another example of such unquantifiable risk is political risk, which includes change of government or drastic changes in long-term economic policies of the government. For example, the international community of investors keenly follows the government's commitment to economic reform. For example, since the 90s, successive governments were judged on whether they would continue with the open economic policies. No wonder, we are still drawing huge foreign capital because of successive governments that have pursued the reform agenda. In the past, investors have seen nationalisation of businesses and shift from democratic to dictatorship form of governments hurting their interests. For example, just imagine what will happen if insurance companies or the banks were to be nationalised immediately.
However, though you can be aware of these risks you can't obtain an insurance cover against them. For example, if you are investing in a mutual fund scheme that invests money abroad, you are exposed to geopolitical risks. But can you do anything about the risk? Well, precious little. The best way to mitigate this risk is to have a diversified portfolio. Also, investors can invest across markets with no or low correlation with each other. For example, Latin American markets have low correlation with Indian markets. The low correlation is an outcome of contrasting nature of these economies. Latin American countries are commodity producers whereas the Indian economy is primarily a consumer of commodities. Investors should restrict their exposure to those countries whose geopolitical scenario they understand.
