There is a post-Brexit notion floating about that the majority vote to leave the European Union (EU) caught everyone by surprise. It reminds me of an equity investor who expresses complete shock when markets drop. Therefore, let us begin by remembering that, “Leave” was always a possibility, and markets go both up and down. Thus, it is not shock and surprise that are making post-Brexit markets feel so queasy; it is deep unpreparedness.
After Brits voted to leave the EU, global markets reacted with swift instinct. Treasuries, gold, the Yen, and other safety assets rose sharply while equities, oil, and most growth assets declined just as quickly and significantly. The British Pound itself was hit hard, losing over 8% to the U.S. Dollar. It was pretty messy. Yet fear in markets following the EU referendum was actually quite predictable; if there is anything markets have consistently shown throughout history, it is a recurring need to panic (think Black Monday or subprime mortgages, or more recently Greece’s budget woes). Post-Brexit trading losses were discussed as if it was the first time investors had ever run for cover, but markets should be used to a wild, reactionary environment that is more the norm these days than the exception.
A Textbook Lesson in Correlation
This leaves each of us two choices when it comes to the interplay of momentous geopolitical events and our money:
- React with panic as if the outcome — and subsequent volatility — was totally unimaginable
- Prepare ahead of time for the inevitability of volatility.
Markets’ movements in the wake of the Brexit vote are a textbook lesson in correlation. Often financial advisors teach (and preach) diversification and it falls on deaf ears. Then sometimes correlation unfolds, unmistakably, right before our eyes for all to see. Yes, many stocks plummeted in backlash to Brexit and paper wealth was lost globally. However, many assets appreciated, including bonds, currencies, metals, and even agriculture. For example, on the Friday after the vote, in response to Brexit, U.S. Treasuries gained a double-digit return. The reaction from markets to Brexit was the personification of correlation. There were many rushing toward safety — these are the investors who did not prepare using correlation to properly diversify. And then there are some, despite the hasty downturn in both global markets and sentiment following the EU referendum, that sit in a position of strength due to the use of correlation in constructing their investment portfolios.
The Bottom Line
Market reactions to the Brexit vote illustrate that unpreparedness causes panic, and panic impacts performance. Nonetheless, for those that understand correlation in a portfolio, the inevitability of volatility is filled with opportunity to reduce risk and increase return.