Brexit’s Stock Market Lesson

The unexpected vote by United Kingdom citizens to leave the European Union left forecasters scratching their heads and investors running for cover.

In the two days after the Brexit vote, the S&P 500 lost more than 5 percent of its value. I overheard people discussing how they’d “lost thousands of dollars” in two short days. (Things have, of course, evolved since then.)

During such market turmoil, I have three things I like to keep in mind:

1. This is yet another reminder that market forecasters do no better than monkeys throwing darts. In the case of this recent turmoil, the “market” as well as most of the experts clearly did not expect a “leave” vote. This is just another reason to ignore advisors and commentators that offer predictions. Even when they get predictions right, there’s no telling whether it was just a lucky guess.
2. Those of us with long-term plans have to pay the price of short-term fluctuations, by maintaining exposure to higher expected return assets, such as volatile common stocks, over the long term. These short-term “losses” in stocks are not “realized” unless you sell, and I have no plans to sell stocks. During the infamous Black Monday in 1987, the S&P 500 dropped 20 percent in a single day. Investors who sold “locked in” those losses. Investors who stayed the course saw the market rise by 15 percent in just the next two days. Investors with a long-term focus saw the market rise by more than 200 percent over the next 10 years.
3. Third, and perhaps most importantly, this is why prudent investors and advisors preach diversification. Over the last few months and years, U.S. stocks have outperformed most other options. High quality bond yields have dropped below 2 percent. With little upside for bonds and continued momentum for U.S. stocks, many advisors have started pushing clients more and more into U.S. stocks. While I believe that a significant share of your portfolio should be devoted to stocks in order to create long-term growth, there is always a need for cautious diversification that includes a position in bonds even when yields and expected returns are low.

Let’s consider the recent Brexit unpleasantness, which provides a case study of my three-part reaction to short-term market chaos. A well-diversified portfolio will typically hold assets that include real estate (REITs), investment grade bonds, U.S. and international stocks, emerging markets stocks, and often gold and cash.

Over the two days when the S&P 500 dropped by more than 5 percent, these other asset classes had very different returns. International stocks, dragged down by Europe, did even worse than the U.S. However, some of these assets actually rose in value and acted to buoy the returns of a prudently constructed portfolio.

Vanguard’s Total Bond Market ETF (ticker: BND) was up more than 1 percent in those two short days. So much for the market prognosticators that told us that bond prices had nowhere to go but down.  SPDR’s gold ETF (ticker: GLD) was up about 5.5 percent over these two days. So much for the folks that told us that gold has no place in a portfolio. Real estate, as measured by Vanguard’s REIT ETF (ticker: VNQ), was down less than 1 percent.

Altogether, a well-diversified portfolio made up of these asset classes may have been down about 2 or 3 percent over those two lousy days. Nobody wants to see their portfolio down, but this is far better than dropping by 5 or 6 percent.

When the headlines blare about market disorder, maintain your long-term focus and keep in mind that this is exactly the purpose of a diversified portfolio.

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American Investment Services, Inc. (AIS) is an S.E.C. Registered Investment Adviser founded in 1978. AIS is wholly-owned by the non-profit scientific and educational organization American Institute for Economic Research.