How Should “Brexit” Affect Your Investing Decisions?
- Stock markets fell in June in response to Brexit vote
- The British pound fell significantly along with the Euro versus the US dollar.
- Uncertainty will continue for a long time as negotiations will take a long time.
- Risk management and systematic decision-making are the key to success in this environment.
- Investors in a dynamic asset allocation program that manages risk should avoid worrying about the headlines and just enjoy their lives.
During World War 2 the motivational poster “Keep Calm and Carry On” was produced by the British government to raise morale in the face of air raids on London and other major cities. The effect on the culture was to reinforce a generation of Brits with a “stiff upper lip” in the face of adversity- keeping their emotions in check and focusing on taking action. Ironically the surprise Brexit vote seemed to be a rare case where Brits voted with their hearts instead of relying purely on the facts. Cursory analysis would show that in the short-run a full Brexit would be economically costly, while in the long-run the future would be highly uncertain. In other words, the result of leaving would be much more of a pure gamble. There is no script to follow given such an unprecedented move and currently there are no politicians willing to step up to manage the country (politicians hate lose/lose situations). The vote was symbolic of a rejection of elitism, and a big push back against the trend of globalization. It is the same “anti-establishment” trend that is helping Donald Trump gain momentum across the pond in the United States.
It was the older demographic with memories of a better past that were ultimately the force behind the surprise vote to exit the European Union and regain British independence. On the opposite side of the fence, the majority of younger voters chose to remain. Many of the leave camp were probably disillusioned by a variety of factors including the sagging economy and the dilution of the British culture that they grew up with. The younger voters in contrast have yet to feel the burden of long-term financial obligations and feel accustomed to the diversity and new culture and enjoy the mobility within the European Union.
So what will come of the vote to Brexit?
Ultimately the referendum has no legal clout: the Brits do not have a formal constitution and therefore the government can do whatever it wants and ignore the results. It is entirely possible that there will be another referendum or the parliament may choose to modify the terms of membership within the EU. Alternatively parliament could negotiate with the EU the terms of Brexit.
The bottom line is that everything is completely up in the air.
If the Brexit becomes a real possibility then the entire status of the European Union is threatened with dissolution. The breakup of the EU and the failure of the Euro would introduce massive amounts of volatility into the market and possibly cause a major recession. Many of the member countries of the EU would be forced into bankruptcy and the sovereign debt holders and financial institutions that have exposure would have to take severe losses. That is why Brexit is being called a “Lehman Brothers moment” recalling the importance of that event as a catalyst that preceded the last financial crisis in 2008. But this scenario only becomes a reality if there is follow through and the impacts on the EU are actually realized.
How does one manage a portfolio during such uncertainty?
Many discretionary managers were caught completely flat-footed by positioning their portfolios on the expected Bremain vote. In contrast many systematic or rules-based managers did well during the month. June was also one of the best months for our models in a long time. Our risk management and diversification helped to significantly buffer volatility and harvested returns from the crisis. Since the Brexit vote was so unexpected, the resulting fallout reminded me why having a quantitative approach that self-corrects to follow market action is so important: the computer doesn’t have any opinions- it simply watches and responds by reducing exposure during risky conditions. What was also noteworthy was that we have not had any exposure to the European stock markets which got hit the hardest during the month and have not had exposure for some time. That is the benefit of watching momentum – the smart money was indicating that risks were increasing for Europe for some time and this was reflected in underperformance versus domestic equities. As a consequence, we only had exposure to the better performing domestic equities.
Watching the volatility closely and reading the headlines this month could have led to many sleepless nights for investors and portfolio managers. The purpose of having a systematic model that manages risk is to relieve both investors and the portfolio manager from making poor decisions under stress. No one knows what will happen in the highly uncertain future, and therefore the ability to correct course in stormy markets with speed and precision is a huge benefit. We feel that investors should stay calm under the circumstances and let the model do its work. Worrying about the headlines is a waste of time, instead, just spend time enjoying life knowing that computers don’t need any sleep.
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