Managing the unmanageable: a long-term approach to geopolitical risk
By Joven Lee, Multi-asset Strategist at Schroders
Even without recent events in the Middle East, geopolitical uncertainty is an increasing worry for investors. What can historic market performance tell us, and how can investors develop a process to address this risk in their portfolios?
Attempting to trade geopolitical risk directly has historically proven challenging and, in many cases, counterproductive. Geopolitical events are rarely anticipated with sufficient precision to allow for timely portfolio adjustments, and positioning decisions taken in response to unfolding events often introduce significant timing risk without reliably improving outcomes.
By the time a geopolitical shock becomes apparent, markets may already have partially priced in the associated risks – or may ultimately choose to look through them altogether.
Market reactions to geopolitical developments are also highly inconsistent. Similar events can generate markedly different outcomes depending on the broader macroeconomic backdrop, prevailing valuations, and policy environment. In some cases, periods of elevated geopolitical tension coincide with sharp drawdowns in risk assets; in others, markets remain resilient or recover quickly. This variability makes it difficult to establish stable, repeatable trading rules around geopolitical risk.
Is there transmission into the wider economy?
One reason for this inconsistency is that geopolitical shocks transmit through multiple channels. These include shifts in broad risk-on/risk-off sentiment; disruptions to energy and commodity markets – which have become a keenly watched transmission mechanism in recent years – as well as changes in inflation expectations. As an example of how interconnected these factors are, disruptions to energy markets also sometimes impact inflation expectations. Furthermore, while not strictly a geopolitical event, trade restrictions or tariff policies can alter the inflation outlook even in the absence of immediate economic disruption. Geopolitical developments can also influence policy responses, shaping fiscal decisions and altering the reaction function of central banks, further complicating the market response.
Crucially, heightened geopolitical risk does not automatically imply market drawdowns. Historical experience shows that while volatility often rises during periods of geopolitical stress, negative returns are far from guaranteed. This underscores the difficulty of using geopolitics as a reliable trading signal and reinforces the case for addressing geopolitical risk through strategic portfolio construction rather than short-term tactical positioning. This is an approach that ultimately requires a research-intensive investment framework to distinguish signal from noise.
Evidence from history: what happens to portfolios during heightened geopolitical events?
Historical analysis of geopolitical risk often relies on frameworks such as the Geopolitical Risk (GPR) Index, which captures the intensity of geopolitical tensions through news-based measures. While such frameworks are useful for identifying periods of heightened geopolitical stress, they should be viewed as measurement tools rather than forecasting devices. Spikes in geopolitical risk can help define event windows for analysis, but they do not, in isolation, explain market outcomes.
Empirical evidence suggests that asset performance during periods of elevated geopolitical risk is highly variable. In Figure 3 below, we show how each geopolitical event impacted US equities. Each grey line represents a geopolitical event (see footnote), and we can see the large dispersion of returns across the events, with the mean being slightly positive. This suggests that geopolitical risk, in isolation, is not a sufficient basis for forming a directional view on financial markets, regardless of how salient it may feel at the time.
Equities tend to experience increased volatility, while the direction and persistence of returns depend heavily on the prevailing macroeconomic and financial environment. Fixed income, commodities and real assets respond through different channels, often reflecting whether the shock is perceived as growth-, inflation- or policy-driven. As a result, it is difficult to isolate the precise contribution of geopolitical risk to market performance, as geopolitical events rarely occur in a vacuum.
Recent history illustrates this challenge clearly. The Russia–Ukraine war and the Israel–Hamas conflict both involved active military confrontation, yet market outcomes differed markedly. The outbreak of the Russia–Ukraine war in 2022 coincided with a period of rapidly tightening monetary policy, as central banks – particularly the US Federal Reserve – responded to surging post-pandemic inflation. Financial conditions tightened sharply and equity markets experienced significant drawdowns. By contrast, the Israel–Hamas conflict occurred against a backdrop of relatively accommodative financial conditions, improving inflation dynamics and the early emergence of the artificial intelligence investment theme, all of which helped support risk asset performance despite heightened geopolitical tensions.
Taken together, these episodes highlight a consistent theme: geopolitical risk can act as a catalyst for market volatility, but its ultimate impact on portfolios is largely shaped by the surrounding economic, policy and financial context. This reinforces the difficulty of drawing simple conclusions from individual events and the importance of approaching geopolitical risk through a broader portfolio lens.
How to manage the unmanageable: a portfolio construction lens
From a portfolio construction perspective, resilience is best achieved through diversification across economic regimes and exposures that respond differently to shifts in growth, inflation and risk aversion. Rather than relying on a single defensive asset or isolated tactical adjustment, portfolios benefit from combining multiple return drivers that perform under contrasting macro conditions. This approach reflects the reality that the market impact of geopolitical shocks is highly context-dependent and shaped by the broader economic environment in which they occur.
Importantly, diversification is not without cost. Assets that provide protection during periods of stress may lag in more benign market environments, and their contribution to portfolio outcomes is often only evident during episodes of heightened volatility. This trade-off lies at the heart of diversification: the value of resilience is typically revealed precisely when it is most needed.
Rather than attempting to anticipate the next flashpoint, investors are better served by focusing on how portfolios are constructed ahead of uncertainty. Diversification across economic regimes, return drivers and asset characteristics remains the most robust response to geopolitical risk.
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