The recent events in Ukraine remind us that major geopolitical events are a constant element of the investment landscape.
Geopolitical events, such as war and terrorist attacks, can have material impacts on the stock and bond markets because of their effect on the economy, corporate profits, and inflation. It usually takes a period of time for the markets to assess the financial implications of any geopolitical event which can cause increased market volatility.
The situation with Russia and Ukraine is a good example of how a contained geopolitical event can have a ripple effect on the global financial markets. For example, while both the Russian and Ukrainian economies are relatively small on a global basis, both countries play a material role in major sectors of the global economy. In the case of Russia, it is major supplier of oil and natural gas to the global energy markets.
In the case of Ukraine, it is a major supplier of wheat and grains to the global food markets. So, while neither country has a material direct effect on the U.S. economy, for example, the conflict does have global inflationary implications which, in turn, can have a material indirect impact on our and other economies in the form of rising consumer prices, rising energy costs, rising industrial input costs, and prices of manufactured goods.
When assessing the impact of geopolitical events on the financial markets, it is important to provide some historical perspective. History shows that geopolitical events tend to have little lasting impact on the financial markets. A recent study by Vanguard that analyzed eight major geopolitical events over the past 60 years shows that the average decline in the stock market following the event was about 4% and the decline lasted about 37 days. The average recovery in the stock market following these eight events over a six and twelve month period was 5% and 9%, respectively, which is about in line with long-term average returns. The longest decline following a geopolitical event was 19 days following the launch of Sputnik 1 in 1957 in which the market declined 10% and took 215 days to fully recover.
Can we prepare for geopolitical uncertainty in investing? The answer is yes. While we may not know exactly how the current (or any crisis) plays out, we do know that asset class diversification is the best way to protect one’s portfolio against events like these that cause increased market volatility. The portfolios we manage for our clients are diversified across nine asset classes. This helps to dampen portfolio volatility because of the differences in correlation of performance between asset classes. Asset class diversification has shown to not only reduce portfolio volatility but also increase risk-adjusted return, which I believe is the most important measure of return in managing assets for clients.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.