Proinsias O’Mahony: Brexit – six lessons for investors

Just over a month ago, British voters stunned the world by voting for Brexit. Markets tanked before staging a mighty rebound that has taken many by surprise. What lessons can investors learn from the Brexit rollercoaster?

1 Diversify, diversify, diversify

Brexit hit some national indices and sectors harder than others. Bank stocks were pulverised; many of Europe’s largest financials quickly lost a third of their value or more and remain well-shy of pre-Brexit levels.

The FTSE 250, which is heavily focused on the UK economy, has badly underperformed the multinational-dominated FTSE 100. The Iseq was one of the worst-hit indices. It endured a two-day fall of 17 per cent and the subsequent rebound has not looked particularly convincing.

Brexit represents a costly lesson regarding the benefits of diversification and the dangers of home bias. Four companies – CRH, Ryanair, Kerry Group and Paddy Power Betfair – make up more than two-thirds of the Iseq’s stock market capitalisation. The index’s narrowness means it is always vulnerable to sudden drawdowns.

Similarly, UK investors guilty of home bias must be looking on enviously at those who took a diversified approach. In sterling terms, British equity investors with international portfolios would actually have enjoyed sizeable gains over the past month, due to the pound’s precipitous decline. US investments, meanwhile, have shrugged off Brexit, with the S&P500 continuing to hit all-time highs.

Clearly, Brexit is a reminder that the old cliche about diversification being the only free lunch in finance remains an apt one.

2 It pays to know your market history

Ordinary investors could be forgiven for being perplexed as to the stock market reaction to Brexit. It’s not uncommon for stocks to rebound following a steep market plunge, but not many investors expected the FTSE 100 to hit an 11-month high in the process. Nor did many investors expect the S&P500 to hit all-time highs within weeks of a serious market shock.

Stock market history, however, shows market shocks tend to be less impactful than one might assume. Stocks were pummelled in the aftermath of the 9/11 attacks in 2001, for example, but the S&P500 had recouped its losses within 19 days, and this is not an isolated example.

Last year, Credit Suisse analysts took a look at the data, and found “the large majority of individual major events – ranging from the assassination of Archduke Ferdinand 100 years ago through to 9/11 and recent events in Iraq and Ukraine – impact major stock markets by around 10 per cent or less, with the effect being fully reversed within a month or so”.

This doesn’t mean the post-Brexit rally was in some way inevitable – it wasn’t. However, nor was the rebound some strange aberration; anyone familiar with history will know that it rarely pays to sell up in the aftermath of market scares.

3 Every scare is not a ‘Lehman moment’

Former Federal Reserve chairman Alan Greenspan was spooked by Brexit, describing it as "the worst period I recall since I've been in public service". Influential economist and former US treasury secretary Larry Summers was similarly nervous, tweeting that Brexit was "the worst shock since WWII & central banks are out of ammo". "Is 'Brexit' Europe's Lehman Brothers Moment?" headlined the New York Times.

Such warnings have become wearily familiar. “As in August 1997, 1998, 2007 and 2008, we could be in the early stage of a very serious situation,” Summers tweeted last August, during the China-induced global growth scare. The Greek debt crisis, easy money from central banks, the oil price crash and innumerable other market scares in recent years have catalysed agonised warnings that another “Lehman moment” may be at hand.

Once, such dire warnings would have been perceived as the sensationalist preserve of the financial world’s more excitable commentators, rather than from figures such as Summers and Greenspan. Like policymakers everywhere, both men did not spot the signs of trouble in the years leading up to the 2008-2009 global financial crisis. Accusations of complacency have been levelled frequently against policymakers, economists and the financial media in the intervening years, and it seems that many commentators want to atone by predicting the next crisis.

The constant search for parallels with the Lehman collapse is understandable, but misguided; inviting edgy investors to flee at the first hint of trouble is bad for both one’s wallet and one’s nerves.

4 Timing is tricky

Strategists often suggest going to cash prior to potential market-moving events such as the June 23rd Brexit vote, the idea being that investors should first wait for the smoke to clear. Getting back in is not always easy though, especially when stocks have staged a strong counterintuitive rally.

Not only that, by the time the smoke has cleared, the next bout of uncertainty is often just around the corner. Asked recently about the prospect of Donald Trump winning the November presidential election, US financial strategist Gary Shilling suggested investors stick with cash until "the smoke clears".

Such advice is not very practical for most people. Long-term investors will probably face "about one so-called market crisis a year", Vanguard founder and index fund guru John Bogle said after the Brexit vote.

“Do you really want to get out of your long-term investments – and then try to jump back in at the right moment – say, 30 to 40 times in the next three or four decades?”

5 Prediction markets are fallible

One month on, it’s still unclear why prediction markets so badly underestimated the prospects of a vote for Brexit. In mid-June, almost every opinion poll showed the Leave camp to be in the lead. Polls in the last week suggested a shift to Remain, but the difference was very small, so why did bookmakers estimate the odds of leaving to be as low as 10 per cent on the day of the referendum?

More crucially, why did the $5 trillion currency markets so casually assume the bookies were right? By the day of the vote, £1 was worth $1.50; sterling had reclaimed all the ground lost in the months leading up to the referendum, meaning that a Leave vote was being viewed as a near impossibility.

Did markets place too much weight on past referendums, where voters turned more cautious close to polling day? Did pro-Remain voters stay at home because they believed their vote was not needed? Were affluent, pro-Remain investors oblivious to the anger of alienated Leave voters? Did the biases of expert forecasters somehow contaminate their models?

Larry Summers’ judgment – “political science is an oxymoron” – may be a little harsh, but investors will surely agree that pundits and punters “should have humility going forward”.

6 Prescience does not always mean profits

Very few investors predicted Britain would vote for Brexit, but let’s say you were one of the lucky few, would you have been able to profit from your prescience?

As noted earlier, not many investors expected the biggest two-day global selloff in stock market history to be followed by the FTSE 100 quickly hitting 11-month highs or the S&P 500 hitting all-time highs.

Economist John Maynard Keynes famously compared the stock market to a beauty contest where you are asked to identify the entrant that other people think to be the most beautiful.

“It is not a case of choosing those that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest,” said Keynes. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

The rollercoaster reaction to Brexit shows it may be easier to heed the advice of legendary author and investor Benjamin Graham rather than playing the beauty contest game. "In my nearly 50 years of experience in Wall Street", said Graham in 1963, "I've found that I know less and less about what the stock market is going to do, but I know more and more about what investors ought to do."