3 Ways to Reduce Political Risk in Your Portfolio

Ever since the 2012 presidential campaign started heating up, investors have been aware of the impact of politics on the stock market. Yet because of ongoing concerns like the fiscal cliff, the debt ceiling, sequestration, and the need for a long-term solution to soaring budget deficits, investors haven't been able to celebrate the typical post-election exit of Washington from the forefront of their minds.

Unfortunately, political risk isn't going anywhere anytime soon. With so many unresolved hot-button issues that lawmakers will address in the coming months, the impact of what the government decides to do in response to those issues could move the markets sharply in either direction.

But there are things you can do to minimize the chances of big disruptions to your portfolio. I'll detail several of them later in this article, but first, let's look at just how nervous investors have gotten about the potential for a Washington-inspired market meltdown.

Dealing with a lack of clarity
UBS did a survey (link opens PDF file) that asked investors with $250,000 or more in investable assets what their biggest worries were about the future of the markets. More than three-quarters reported that they were extremely or very worried about the impact that Washington could have on their investments. Of nearly equal concern were fears about rising health care costs and the size of the national debt, both of which have been closely tied to actions the government has taken in recent years, including health care reform and the massive stimulus packages designed to try to push the economy into a stronger recovery.

These problems might not be so bad if investors thought that the government would actually get them solved. But nearly 80% of respondents expect the same sort of short-term fixes that led to a fiscal cliff compromise on New Year's Day, rather than any more sweeping reforms that would truly address the long-term issues on the table.

How to handle the risk
At the end of the day, you can't fix Washington's problems. What you can do, though, is position yourself to be able to handle whatever happens. Consider these strategies to reduce the risk levels in your portfolio.

1. Invest overseas.
If you look at corporate America, one trend companies have followed for years is to diversify their holdings. In particular, health care insurance giant UnitedHealth (UNH 4.68%) recently turned southward to buy a big stake in Brazil's Amil, a leader in the emerging-market country's health care market. The purchase will help UnitedHealth reduce its exposure to the political process of U.S. health care reform in the coming years.

You can do the same thing in your portfolio by buying foreign stocks and bonds. Afraid that U.S. Treasury rates will have to go up? Consider investing in Aberdeen Asia-Pacific Income (FAX -1.54%), which invests primarily in Australian and other Pacific-region bonds that pay higher interest rates and have more favorable outlooks than Treasuries. Similarly, buying shares of Telefonica (TEF -0.72%) and Banco Santander (SAN -1.62%) exposes you to the political dynamics of Spain, with fears of Catalan calls for secession creating uncertainty about the country's resolve to fix its fiscal problems. Yet despite those political risks, they're largely separate from those facing the U.S., and therefore investing some of your money there or elsewhere in Europe should help protect you from American gridlock.

2. Buy cheap insurance.
One side effect of the huge bull run in stocks lately is that volatility levels have fallen through the floor. At such low levels, buying put options to protect your portfolio from short-term disruptions is less expensive than it often is. It's important to understand that you can lose every penny you pay for put options if a big market downturn doesn't happen. Yet while it may not be a prudent long-term strategy, buying puts is one way to insure your investments against major losses.

3. Get tax certainty.
For those with retirement accounts, future tax liability is a major concern. By converting retirement assets to Roth IRAs or Roth 401(k)s, you can essentially lock in current tax rates, ensuing tax-free treatment for the remainder of your retirement nest egg throughout your lifetime. Granted, with recent tax hikes, a Roth conversion is more expensive than it would have been last year. But with signs of possible future tax increases still lingering, you might want to take advantage of current rates rather than risking further rises.

Stay safe
The current political risk unquestionably has an impact on your investing, but you shouldn't let it distract you from your primary financial goals. By taking prudent steps to reduce political risk without sacrificing potential returns, you can minimize the impact that Washington might otherwise have on your investments.