A couple of days ago, my wonderful doctor-wife asked me: “What is this Brexit thing all about?”. My short answer at the time was that U.K. citizens voted to withdraw from the European Union and that its a huge tangled mess from there. It’s a mess because 1) the vote was non-binding, so no one knows for sure what will actually happen; 2) it will take years for the U.K. to separate from the E.U., if it does happen; 3) Scotland still wants to be part of the E.U. and could try to separate from the U.K.; and 4) other E.U. countries are more likely to leave the E.U.
Beyond the mess that involves what Europe will look like in a few years, Brexit has created a significant amount of uncertainty, which caused stock markets to tank Friday and Monday, while suppressing bond yields to near record levels. The uncertainty comes from the structure-of-Europe issues raised above, the millions of contracts involving companies doing business in the U.K. that need to be reconsidered, and the increased complications of doing business in Europe (especially if other countries look to exit), among other things. Uncertainty then begets even more uncertainty, as the stock, bond and currency market changes over the past couple of days create even more fears of recession in the U.S., Europe and China. These things can become a self-fulfilling prophecy, as people and companies reign in spending (i.e. business activity) while waiting for the uncertainty to subside, even though doing so creates more uncertainty. In other words, how people in the aggregate act in fear of a recession, can actually help cause that recession.
So what should we as investors do? The answer depends on how you are invested and how you feel about your portfolio in light of the recent stock market drop:
- Buy and hold investors should not do anything in light of Brexit. Just continue to make periodic investments in accordance with your investing strategy and rebalance your investments on schedule.
- Investors who are using low-cost, passive funds in a momentum-based strategy to attempt to reduce risk should continue to follow their plan, which may result in moving some investments to cash. Keep in mind that the recent drop, while significant, will just be a blip on a long-term chart, and it is possible that in the next couple of weeks or months, the U.S. stock market will be back where it was on Thursday near all-time highs.
- If you hold individual securities, then take advantage of any opportunities to harvest your losses for tax purposes, and see if any of your favorite companies are now trading at a large enough discount to be worth a purchase. I would not make any large-scale changes to a portfolio based on Brexit, although an opportunity may be opening up to get some high quality banks at a good price.
These types of events are great tests of your risk tolerance. If you are traumatized by Brexit’s impact on your portfolio, then either your risk tolerance is much lower than you think, or you are not appropriately invested. Or more likely, both. If you are a buy-and-hold investor concerned that the stock market is going to drop another 30-40% from here, and you want to jump ship, then either buy-and-hold is not for you, or you need to decrease your stock market exposure. If you want to change your strategy, then 1) talk to an investment adviser who is loyal only to you to make sure you are making the right move; and 2) sleep on your decision for a couple of days before making it.