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Understanding and Managing Political Risk

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International investing can be a powerful way to boost the performance of your portfolio. But investing in foreign markets also involves risks that can sometimes be much greater, or at least more complex, than the risks that investors normally face when investing at home. Political risk is one important example.

What is Political Risk?

For investors, political risk can simply be defined as the risk of losing money due to changes that occur in a country’s government or regulatory environment. Acts of war, terrorism, and military coups are all extreme examples of political risk. Expropriation of assets by the government – or merely the threat – can also have a devastating effect on share prices.

In early 2007, Venezuelan President Hugo Chavez abruptly announced plans to nationalize CANTV, the local phone company. CANTV’s shares plunged almost 50% before the details of Chavez’s plans emerged. Investors sold first and asked questions later.

But political risk comes in many other forms. Other examples include: a new president or prime minister, a change in the country’s ruling party, or an important piece of new legislation. All of these changes can have a big impact on a country’s economic environment and investor perceptions about a country’s prospects.

Managing Political Risk

Unlike economic or financial variables, political risk is more difficult to quantify. While it is possible to calculate political risk “scores” or other quantitative-looking benchmarks, it’s important to remember that these are ultimately based on qualitative judgments. There’s no substitute for doing your own research and coming to your own conclusions.

The Economist’s Country Briefings are a great place to start. These reports contain a wealth of background information a country’s government, politics, and economy. Some questions to keep in mind: Are there any important elections coming up soon? If so, who are the candidates/parties and what are their economic policies?

The name of the game here isn't to avoid political risk completely. Even if you keep all of your investments in the U.S., you are still exposed to decisions in Washington DC. One of the keys to success in international investing is understanding political risk so you can make better decisions.

As with other kinds of risk, the only tried and true method for mitigating political risk is diversification. Be sure to spread your international investments around in a variety of countries and regions so that you won't get hurt too badly even if your political risk calculations turn out to be off the mark.

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