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
