Investors often ask how it’s possible to allocate capital to European stocks given the political risks that abound. We think the answer is to combine disciplined stock picking with risk-management tools that look for unintended threats to a portfolio.

Questions like these peaked at the height of the European debt crisis in 2011. Today, these questions are being asked again with urgency given uncertainty over Brexit, Italian politics and the European growth outlook, as well as potential fallout from trade wars, turmoil in emerging markets and the global growth outlook.

Managing Risk in Stock Selection

Risk can mean many different things to different investors. For some it’s just another word for volatility. For others it’s all about how a portfolio looks versus a benchmark.

We believe managing risk is about ensuring that a portfolio’s returns are driven primarily by the business strengths of its holdings. That means making sure performance isn’t knocked off course—or even boosted unexpectedly—by events or exposures that aren’t related to the businesses.

The first step in effective fundamental risk management is to understand what could go wrong at the company level. Thorough company-level and industry research is essential, for example, to determine how sensitive company earnings are to changes in the macroeconomic environment and to identify environmental, social or governance risks that could damage performance.

But even the best company analysts may have blind spots. So challenging our own perspectives is important. In some cases, this can be done by engaging with short sellers, typically working at hedge funds. Since short sellers are trying to profit from a stock price falling, they have a negative opinion on the company’s prospects. By talking with them, long investors can identify potential holes in a thesis. This can lead us to revisit key assumptions or to revise our return forecasts to compensate for risks that we may not originally have spotted.