You Can’t Fathom the Froot Loops

Story Highlights:

• This week, US markets have been plenty volatile.
• Geopolitical developments in Georgia and Pakistan didn't help matters.
• Geopolitical events, though scary at times, can't be forecasted or planned for.
• Historically, market reactions to geopolitical surprises haven't been what most folks think.

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It was a volatile week in US markets. The big ups and downs left some folks a little shell shocked. And Friday's headlines probably didn't help:

Russia Clashes With Georgia
By Marc Champion and Andrew Osborn, The Wall Street Journal

Pakistan's Musharraf Faces Impeachment
By Munir Ahmad, The Associate Press

The smoldering conflict between Russia and Georgia grew hotter Friday, as Russian and Georgian armed forces clashed in the break-away republic of South Ossetia (the region's northern counterpart lies within Russian borders).

And in nearby Pakistan, President Pervez Musharraf had to cancel plans to represent his country at the Olympic Games in China, citing domestic political concerns. In plainer language, the ruling coalition in the National Assembly is threatening to impeach him.

Or maybe you've been following tensions in the Middle East over Iran's nuclear program. President Mahmoud Ahmadinejad has made every outrageous claim short of having invented the question mark (though he's probably froot loops enough to make such a claim). And on Friday the EU, Iran's largest trading partner, tightened existing trade sanctions.

These developments seem to raise the risk of regional instability, and if volatility's already got you on pins and needles, they might have you wondering whether you should sell out and go to cash. Or heck, maybe stashing some gold bars underneath your mattress would be better.

We think you can hold off on the gold bars and cash. Geopolitical events with the power to move markets aren't as regular as headlines make them seem. All three examples above, though scary, aren't that surprising: Russia and Georgia have been bickering over sovereignty and territory for years, while the Middle East and Pakistan have almost always seemed ready to explode.

What about when a genuine surprise pops up on the front page? Risk seems to constantly be lurking just around the corner in what seems to be a very tense world. But the fact is, there's not a soul on the planet who can predict the real shockers, like terrorist attacks, nuclear accidents, or sudden geopolitical conflicts. And, from a portfolio standpoint, we don't think it makes sense to worry about what you can't plan for (though, as good Californians, we naturally have water stockpiled in our earthquake kits).

Historically, market reactions to geopolitical flare-ups have been a mixed bag—sometimes up, sometimes down, but generally short in duration before they carry on according to the prevailing fundamentals of the day. As for bigger confrontations, there's no reason to expect a negative market reaction. We've seen plenty of examples where stocks were actually depressed in the run-up, but took off once war broke out, alleviating uncertainty. Markets just don't react to geopolitical events the way most folks think.

There's no good strategy for managing a portfolio in expectation something might go awry in this world. It's a case where we should hope for the best, but plan for what's most reasonably likely. Which means not trying to understand what's in the hearts of the froot loops.