Why policy uncertainty is a terrible guide to investing
- Robin Powell
- 27 minutes ago
- 8 min read
The news is full of policy uncertainty: Iran, oil prices, tariffs, inflation. But policy uncertainty is one of the most misunderstood signals in finance. Here's what the academic evidence says about it, and why it matters for your portfolio right now.
You're packing for a week's holiday. The forecast says 'unsettled weather' every single day. Your partner looks at the screen and says: let's cancel. But something makes you check the rain probability. It's 20 per cent. The forecast said uncertainty. The data said bring a light jacket.
That's a pretty good description of what's happening in financial markets right now.
The Iran conflict is escalating. Oil prices have surged. The S&P 500 sold off sharply in March. The VIX, Wall Street's so-called fear gauge, jumped above 30. And the news is wall-to-wall anxiety. War. Recession. Inflation. If you've been fighting the urge to move everything into cash, you're not being irrational. The feeling of danger is real.
The dramatic forecast keeping you up at night and the risk to your portfolio are not measuring the same thing. They're not even close.
Policy uncertainty (what governments might do about trade, conflict, interest rates, regulation) is at extreme levels. Nobody disputes that. But policy uncertainty and market risk are tracked by separate instruments, respond to separate triggers, and tell separate stories more often than you'd think. One is the forecast. The other is the probability of rain.
Investors who confuse the two make the same mistake every cycle: they cancel the holiday. And it costs them.
Everyone's nervous — and the data confirms it
'The fear of the storm is doing the harm — not the rain.'
This isn't just a feeling. The numbers back it up.
The most widely used measure of policy uncertainty, the Economic Policy Uncertainty Index, developed by economists Scott Baker, Nick Bloom and Steven Davis, tracks how often major newspapers mention policy-related uncertainty. In recent months, that index has been running at or near record highs. The forecast says storms all week. And everyone's already cancelled their plans.
Bloom himself, writing in IMF Finance & Development in September 2025, flagged something odd. Text-based measures of uncertainty, the ones driven by media coverage, had surged to new peaks. Yet survey-based measures, which ask businesses about the uncertainty they face in practice, hadn't moved nearly as much. And market-based measures like the VIX, while raised, were nowhere near crisis territory.
Investors, though, were listening to the loudest signal. Retail flows turned negative as people shifted money out of equities and into cash. The pattern is familiar: when front pages scream danger, people sell.
What makes this worse is a finding from the IMF's Global Financial Stability Report in April 2025. Markets react as strongly to the threat of geopolitical events as to the events themselves. The anticipation of disaster does as much damage to investor behaviour as a real crisis.
The fear of the storm is doing the harm — not the rain.
Why policy uncertainty and market risk aren't the same thing
Policy uncertainty and market risk sound like they should move together. They don't. They're tracked by separate instruments, respond to separate events, and diverge almost half the time. Treating one as a proxy for the other means reading the wrong thermometer.
What does each one measure? The Economic Policy Uncertainty Index counts how often major newspapers mention policy and uncertainty in the same article. It's a gauge of media anxiety about what governments might do. The VIX is derived from options prices on the S&P 500, essentially the price traders pay to insure themselves against stock market swings over the coming month. One tracks what journalists worry about. The other tracks what traders are pricing in.
The correlation between them, according to Baker, Bloom and Davis's own data, is just 0.58.
The pattern of divergence is revealing. EPU shoots up around elections, debt ceiling crises, wars and trade disputes. The VIX surges around financial crises: LTCM in 1998, Lehman Brothers in 2008, the pandemic liquidity freeze in March 2020. Political drama fills front pages. Financial stress moves markets. They overlap sometimes, but often they don't.
MSCI's research, published in 2024, puts this even more starkly. Using data from January 1995 to April 2024, they built a composite Geopolitical Uncertainty Index and compared it directly against the VIX. Their finding: the two were 'largely independent'. Financial crises barely registered on the geopolitical index. Geopolitical events barely moved the VIX. The world's biggest index provider concluded that these two types of fear mostly operate in separate lanes.
The most useful finding was what happened to returns. MSCI split months by whether geopolitical uncertainty alone was high, or whether both geopolitical uncertainty and market volatility were high at the same time. Months with high geopolitical fear alone (the kind of environment we're in right now, where the news is alarming but the VIX remains only moderately raised) didn't show the same pattern of poor returns. Only when both measures rose together did equity returns suffer.
That gives you a practical question: is the VIX also up, or is it just the front pages? If it's only the front pages, three decades of data say your portfolio is probably fine.
But if policy uncertainty doesn't reliably predict poor returns, what does happen to investors who sell into it?
Uncertainty pays a premium — but only if you stay
'Selling when uncertainty peaks means selling when the premium is richest.'
Most investors don't expect this. High policy uncertainty isn't just a weak predictor of portfolio losses. It's associated with higher future returns. And investors who sell into it are giving up money.
Lubos Pástor and Pietro Veronesi, in a 2012 paper in the Journal of Finance, showed that political uncertainty commands a risk premium. When governments are unpredictable, investors demand more compensation for holding equities. That's rational; uncertainty is uncomfortable, and the market pays you for tolerating it. But the premium only works in one direction. You have to be in the market to collect it. Selling when uncertainty peaks means selling when the premium is richest.
More uncertainty makes investors nervous. Nervous investors demand higher expected returns before they'll buy. That pushes current prices down. Lower prices today mean higher returns tomorrow. But only for anyone still holding. Scared investors look at falling prices and see confirmation that things are getting worse. The evidence says those falling prices are the market raising the reward for staying.
It's the investment equivalent of buying holiday insurance and then cancelling the holiday anyway.
This doesn't mean you should load up on equities every time a policy crisis hits the front pages. The premium is compensation for risk, not a market-timing tool. But selling out of fear is almost certainly the wrong response.
The IMF's Global Financial Stability Report reinforced this. Even when geopolitical risk is high, real conflicts, real economic disruption, the medium-term impact on financial markets has historically been limited. Stock prices dip. Volatility rises. Both revert relatively quickly, except in the most extreme cases.
So who loses? Investors who sold at the bottom. Morningstar's ongoing Mind the Gap research tracks the difference between the returns investments deliver and the returns investors earn. That gap, the so-called behaviour gap, widens most during periods of high uncertainty. The people who sell during the storm, wait for calm, and buy back in at higher prices aren't reducing risk. They're locking in the cost of fear.
What to do when the front pages are screaming
'Check the radar, not the forecast.'
When policy uncertainty spikes, the right response isn't to react to the news cycle. It's to check your portfolio's risk position: your mix of equities, bonds and cash relative to your long-term target.
Start with the practical test from the MSCI research. Ask yourself: is the VIX also up, or is it just the news? Right now, policy uncertainty indices are at extreme levels. But the VIX, while above its long-term average, is in the mid-20s. Raised, not extreme. The 2008 crisis took it above 80. The pandemic pushed it to 82. A reading in the 20s says the market is cautious, not panicking. If the policy noise is deafening but the market's own volatility measure is merely grumbling, thirty years of evidence suggest your portfolio isn't in the kind of danger the news would have you believe.
So what should you do? Check the radar, not the forecast.
Your portfolio's asset allocation is the radar. It shows you what's real: how your money is positioned right now, after whatever the market has done. The news cycle is the forecast: dramatic, loud, and frequently wrong about the severity of what's coming.
Rebalance rather than panic-sell. If markets have fallen and your equity weighting has dropped below target, rebalancing means buying more of what's gone down. That feels terrible in the moment. It's also what the evidence supports.
A simple checklist for the next time a headline makes your stomach drop:
Check your equity/bond split against your target allocation.
If it's drifted by more than five percentage points, rebalance.
If it hasn't drifted, do nothing. Seriously. Do nothing.
Turn off portfolio notifications during periods of high media anxiety. Those alerts track the forecast, not the radar. They're designed to make you feel informed. What they do is make you feel afraid.
The hardest part of evidence-based investing has never been understanding the evidence. It's sitting still when everything around you says move.
Think about every holiday nearly cancelled because of a dramatic forecast. The week in Cornwall where the BBC said rain every day and you got five days of sunshine. The city break your partner almost vetoed because of 'severe weather warnings' that turned into a light drizzle on Tuesday afternoon.
Brexit was one of those holidays. UK policy uncertainty shot up around the 2016 referendum and stayed high through years of Article 50 negotiations, parliamentary chaos and no-deal brinkmanship. The forecast could not have been more alarming. Yet the FTSE All-Share rose more than 20 per cent between the referendum and the end of 2019. And that's before dividends. The uncertainty was real. The portfolio damage, for those who stayed invested, was not.
The current moment feels different, of course. It always does. Iran feels different from Brexit, which felt different from the pandemic, which felt different from the financial crisis. But the pattern underneath is the same: policy uncertainty is loud, market risk is what matters, and investors who confuse the two pay for it.
You now have a framework. When the next front page hits — and it will — check the radar, not the forecast. Policy uncertainty is a terrible guide to investing. Your portfolio allocation is a good one.
The forecast will keep changing. The radar is yours.
Resources
Baker, S. R., Bloom, N. & Davis, S. J. (2016). Measuring Economic Policy Uncertainty. Quarterly Journal of Economics, 131(4), 1593–1636.
International Monetary Fund. (2025). Geopolitical Risks: Implications for Asset Prices and Financial Stability. Global Financial Stability Report, April 2025, Chapter 2.
MSCI. (2024). Understanding Geopolitical Risk in Investments. MSCI Research and Insights.
Pástor, L. & Veronesi, P. (2012). Uncertainty about Government Policy and Stock Prices. Journal of Finance, 67(4), 1219–1264.
Some things are easier to watch than read
Our YouTube channel covers the same evidence — visually, concisely, without a sales pitch in sight. New videos every week. Subscribe and they'll come to you.