The investment environment is difficult these days. Investing in companies or industries that seemed a safe bet a few years ago now seems much more uncertain. Many factors are contributing to the volatility of the current picture. Regional wars, unstable governments, and a growing climate crisis are just some of the threats to economic growth and stability. Despite this volatility, returns over the past 40 years have tended to be higher than average returns over the past century.

If you’re an individual investor, or you invest through a broker or an investment institution, you may have more to worry about than simply the return on your investment. You could be concerned that your investment could disappear completely, following a military, political or natural disaster.

What precautions can you take to hedge your investments against these threats?

The meaning of liquidity

Different investments have different levels of risk, which are related partly to their levels of liquidity. Liquidity is an asset quality – it measures how easily and quickly you can convert an asset or security into cash or a cash equivalent. Liquidity risk measures the risk involved in converting assets, securities, or bonds into cash without affecting their market price, which may depend on whether economic conditions are favourable or unfavourable at the time of conversion.

A change in these market conditions is a financial risk, because it may cause sudden cash flow restrictions if you’re invested in assets like physical property. An unforeseen change in circumstances or a full-blown disaster could leave you, as an individual investor, unable to meet your short-term cash requirements or debt obligations.

In investment terms, marketable stocks and bonds are more liquid, meaning you can convert them into cash easily. On the other hand, large, fixed assets such as land, buildings, factories and machinery may pose significant liquidity risk in the event of a natural disaster, war, or civil collapse. Finding suitable buyers for these assets with enough capital, especially if the economy is not in good condition, makes liquidating such assets a slow, difficult process.

Hedging and diversifying investments

In the face of market uncertainty related to political, macroeconomic and climate factors, diversifying your portfolio with some hedge investments is a good way to reduce potential risk. A hedge is an investment that reduces potential losses in other investments, because its price tends to move in the opposite direction.

This strategy works as a kind of insurance policy to offset any steep losses in other investments. Hedging can be buying shares in a conservative bond fund to offset potential losses in more volatile stock funds. A simple hedge like this may work at times, but at other times both conservative bonds and stocks have simultaneously experienced losses. A more direct means of hedging involves trading in derivatives. These can be effective hedges, because their relationship with their underlying assets is clearly defined at prices that are agreed by that market. Derivates tend to be complicated, come at a cost, and may introduce credit risk to the party providing the derivative. If you’re investing as an individual, discuss possible hedging techniques with your investment adviser or wealth manager to mitigate any potential losses.

However, a hedging strategy through diversification won’t protect your investment portfolio from acts of nature, where potential losses can’t be predicted. In the past, these disasters were limited to occasional catastrophes like hurricanes or earthquakes, but they have become less unusual as climate change gives rise to more wildfires and extreme weather events.

You and your investment adviser may associate disasters with higher risk to your portfolios, but from an investment perspective, not all disasters pose the same risk. If a country suffers a natural disaster like a pandemic that is no one’s fault, foreign investors who hold that country’s bonds may continue to invest despite the temporary downturn in the investment. On the other hand, if a company is responsible for a technological disaster like a nuclear power plant explosion, it will face loss of reputation, legal action, and disinvestment.

Keeping track of disasters

Unsurprisingly, the market has responded to the volatility introduced by natural disasters by creating an investment category linked to insurance against the losses that disasters cause. Insurance-linked hedge funds generated 14.4% returns in 2023 against an average hedge fund return of 8%.

These funds predominantly invest in ‘catastrophe bonds’ – financial instruments that transfer the risk of natural disasters from insurance companies to investors. These investors stand to gain higher yields in return, but they risk losing their principal investments if a specific disaster occurs. Although these represent the opportunity for high returns relative to hedge funds, they are also incredibly high-risk because of the increasing frequency of these events.

In the USA alone, climate change has brought about a massive increase in the number and severity of natural disasters with very real economic consequences. In 2023 natural disasters cost the world’s biggest economy US$28 billion, in contrast to the previous high of US$22 billion in 2020. This has made certain exchange traded funds linked to disaster recovery and prevention popular and profitable.

This climate phenomenon is not confined to the USA. Internationally, weather disasters in 2023 included typhoons in China, Philippines and Taiwan, droughts in Argentina, China, Spain, Italy, France and India, floods in South Africa, China, Greece, Libya, Italy, Bosnia, Croatia, India, New Zealand, Brazil, Uruguay, Chile and Mexico, and wildfires in Greece, Canada and Australia – to list just a few. Combined, weather-related disasters amounted to more than US$70 billion in direct costs.

Nedbank offers a full range of investment advice and support for both individual and business investors.