That’s according to AMP Capital’s head of dynamic markets, Nader Naeimi. In a market watch insight, Mr Naeimi said the Australian High Court’s decision to rule Deputy Prime Minister Barnaby Joyce ineligible to sit in pParliament “sent tremors through equity and currency markets”.
Calling this a clear sign that political risk matters to markets, he said some investors have “simply forgotten” about political risk and are instead focusing on maintaining highly concentrated portfolios.
He said this behaviour exposes investors to the fallout of political shocks that could be the result of the US political situation, Brexit or a nuclear confrontation with North Korea.
“To protect against heightened risk to portfolios, advisers and investors need to begin assessing political risk objectively from a multi-dimensional perspective,” he said.
1. Think about the probability of the risk
“The first step is to put some probability on the risk of the event happening,” Mr Naeimi said.
He explained that as the Brexit referendum drew closer, it was believed that there was a 50 per cent chance the leave vote would win and a 50 per cent chance the stay vote would win.
However: “The market was pricing in a much higher probability of Britain remaining — 80 per cent. Financial markets were pricing in the prevailing view in London and ignoring the rest of the country.
“The market, therefore, hadn’t priced in the risk of Brexit, especially in the pound. We took advantage of that gap and took a short position in the pound as a hedge.”
2. And the impact
Considering the actual impact of a political event is the next step in managing risk, he continued.
“If the impact is likely to be extremely high, then it may make sense to move to help protect your portfolio. A North Korean nuclear attack might be unlikely, but the impact would obviously be horrific,” he explained.
At the same time, it’s critical that investors understand that the possible impact can be overstated.
While the market “frets” about the possibility of President Donald Trump being impeached, AMP Capital believes any impact of an impeachment would be “relatively low”.
“The impact might be high in the short term, but not in the long run,” he elaborated, explaining that the risk was one on AMP Capital’s radar, but not one that requires action.
“For the first time in eight years we have the Republicans in control of both the Senate and the House and they are motivated to get a fiscal package announced before the mid-term election in 2018.”
3. Is that bad scenario priced into the market?
For investors, it’s important to ask whether the political risk of a potential scenario is priced into the market. According to Mr Naeimi, if “everyone is talking about a political risk”, then chances are it’s already been priced into the market.
By this point, “it’s too late for us to do anything”, he added.
However he pointed to other measures like volatility and sentiment measures which can provide guidance.
He explained: “Low volatility and crowded positions usually mean investors are not pricing in risk. Conversely, if investors are avoiding or have sold out of a position, volatility is high, valuations are cheap, and everyone is talking about it, then political risk is likely priced in.”
Likewise, sentiment measures can be used to assess investor appetite. If there’s enthusiasm about the downside, then the bad news is already priced in. However, if the enthusiasm is leaning more towards the upside then the risk usually is not priced into the market, he explained.
4. Build a portfolio that has risk factored in
“The final step is to construct your portfolio to account for the risk. That may involve using put options, shorting an asset class, or using currencies to hedge,” Mr Naeimi advised.
Looking at North Korea, the relatively low probability of an attack and the severe impact of an attack, the AMP Capital analyst said investors could require some protection like a tail hedge, which protects against extreme, but relatively unlikely, market events like a nuclear attack.
He said: "What is an asset class that would benefit in the unlikely event of a North Korean attack? Gold. Because the probability of an attack is low, we have a small 3 per cent allocation to gold. But if North Korea attacked, the impact would be so huge that the small allocation to gold is likely to multiply upwards of 300 per cent."
Historically, political events have had the capacity to damage portfolios and surprise investors.
Mr Naeimi said the next reaction is usually investor panic before selling at "exactly the wrong time".
"By firstly being aware of political risks, then objectively assessing those risks, investors can remove that emotional element and better prepare their portfolios to weather those risks. Not only is their portfolio potentially going to benefit, but their fears around investment performance and volatility will also ease."
However, to the managing director at Hyperion Asset Management, Tim Samway, it's crucial that investors have the ability to discern between what he calls "market-noise" and genuine risks.
He told Nest Egg that investors need to break attitudes of "short termism" as investment is more than a game of buy and sell.
"The problem is for most people... they feel like they need to be doing something," he said.
"There's an awful lot of information that's produced every day that is, effectively, not valuable and is just noise," he said. "One of the keys to successful funds management is determining what is noise and what is valuable."
Continuing, Mr Samway said investors should be wary of tangling themselves up by "trying to work out what the macro view of the world is" and should instead focus on companies that can build themselves over time.