History on the run
When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors keep their nerve.
At the end of June, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed up possible consequences.
Reporting on the result, The Washington Post said the vote had "escalated the risk of global recession, plunged financial markets into freefall and tested the strength of safeguards since the last downturn seven years ago".1
The Financial Times said 'Brexit' had the makings of a global crisis. "(This) represents a wider threat to the global economy and the broader international political system," the paper said. "The consequences will be felt across the world."2
Now it is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain's prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.
But markets have functioned normally. Indeed, within a few weeks of the UK vote, Britain's top share index, the FTSE 100, hit 11-month highs. By mid-July the US S&P 500 and Dow Jones industrial average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially on the vote.
On currency markets, the pound sterling fell to a 35-year low against the US dollar in early July. The Bank of England later surprised forecasters by leaving official interest rates on hold.
Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange's volatility index or 'VIX'3. Using S&P 500 stock index options, this index measures market expectations of near-term volatility.
You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the Euro Zone crisis of 2011 and the severe volatility in the Chinese domestic equity market in 2015.
None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second guess markets and base a long-term investment strategy on speculation.
Another recent example of this tendency came shortly after the Brexit vote, in the Australian general election, where a much closer-than-expected result sparked media speculation of severe economic and market implications.
In the Sydney Morning Herald, journalists said Australia faced a "protracted political and constitutional crisis", leaving spooked financial markets on edge, investment stalled and the country's credit rating on the brink of a downgrade.4
By the end of the first day after the vote, however, Reuters reported that Australian shares had risen as "surging commodity prices" overrode political uncertainty. After a brief blip, the Australian dollar rebounded to where it was before the poll.5
A week later, late counting in the most marginal constituencies gave the incumbent Liberal-National Party Coalition the barest majority in the House of Representatives, allowing them to form a government.
Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed "growing concern" over how the race might play out.6
Given the examples above, would you be wagering your portfolio on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote you have to correctly guess how the market will react.
And think about this. Even if you do get it right, what's to say some other event might steal the markets' attention in the meantime? The world is complex and unpredictable. No-one really can be certain about anything.
What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on how you are tracking relative to your own goals.
The danger of investing based on what just happened is that the situation can change by the time you act, a "crisis" can morph into something far less dramatic and you end up responding to news that is already in the price.
Journalism is often described as writing history on the run. Don't get caught investing the same way.
1. 'Brexit Raises Risk of Global Recession as Financial Markets Plunge', Washington Post, 24 June 2016
2. 'Brexit and the Making of a Global Crisis', Financial Times, June 25 2016
3. 'VIX' is the tickers symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".
4. 'Political and Constitutional crisis Leaves Turnbull Fighting on All Fronts', SMH, 4 July 2016
5. 'Aussie Recovers from Shaky Start', Reuters, 4 July 2016
6. 'Investors are Finally Getting Nervous about the Election', CNBC, 13 July 2016