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Brexit Induced Performance

As many of you know, the United Kingdom voted to exit the European Union, an event being widely referenced as “Brexit.” Friday’s Brexit induced market losses were rough for investors. The below table summarizes the performance of key market barometers.

U.S. stocks fell between 3.6% to 4.0%. International stocks, particular those of developed countries which are primarily in Europe, fell 8.6%. Commodities, driven primarily by the price of oil, fell more than 3% while real estate held up well with a relative small loss. Gold and U.S. Government Bonds both moved higher, demonstrating, once again, that they tend to be viewed as a safe haven during volatile times.

Significant one-day losses and heightened volatility undoubtedly cause many investors to be concerned. These are valid concerns and concerns I fully appreciate. That said, investing is a marathon, not a sprint. Brexit will clearly have long-term implications but that does not require changing your long-term investment strategy.

Surprise!

I have to admit that I’m fascinated by the surprise leave vote by Britain. It’s actually not the vote for them to leave the EU that fascinates me but the fact that investors worldwide, on average, clearly were not expecting this! That’s really incredible in my opinion.

The Brexit surprise is just another example of a wrong forecast. At the close trading on Thursday, investors were clearly of the opinion that Britain would vote to remain in the EU. The reaction on Friday made this clear. Had the leave vote been anticipated, you would not have seen the volatility and declines on Friday. Instead, you would have seen market prices declining in the days before the vote.

A market barometer that gets a lot of attention during these times is the Volatility Index, or VIX for short. Volatility refers to the magnitude with which prices go up and down. The Brexit induced performance provides a great opportunity to better understand this popular index.

Many investors are under the impression that the VIX anticipates future market volatility but that’s simply not the case. On the contrary, as illustrated in the above graph, the index was a poor predictor of Friday’s volatility. On the day before Brexit, the VIX measured an 18% decline in volatility, one of its biggest single day drops. This tells us that investors were becoming less concerned about market risks. Then, as you can see in the graph, the surprise leave vote resulted in volatility jumping nearly 50%.

You’re going to hear a variety of investors suggest they were anticipating a leave vote and, without question, some actually were. There will always be some who guessed correctly due to pure luck. Most importantly, remember that investors vote with their money. Clearly investors anticipating a leave vote were in the very small minority given the market’s performance prior to Friday.

The “big money” or professional, institutional investors with billions of dollars to invest, often also called the “smart money”, missed this Brexit forecast by a mile. It’s a reminder to be leery of all forecasts, even those forecasts that, on days like Thursday before the vote, seemed so obvious.

Perspective, Outlook, and Advice

A little perspective on Friday’s performance will hopefully be helpful. The Dow Jones Industrial Average closed at 17,400 on Friday, down 610 points. This closing price is just -3.8% from its 2016 high and about the same price it was just 3 months ago. Furthermore, since the start of the year the Dow is down just 25 points, or 0.14%! This is disappointing but entirely normal behavior and performance for stocks…a reality all of us as long-term investors must accept.

Dow Jones Industrial Average

Year-to-Date: -0.14%

I don’t have an outlook as to where markets go from here. It’s impossible to know. I have read and listened to a tremendous amount of commentary from others about what to expect next. What I’m reminded of is that if I read and listen to enough such commentary, I will find experienced people positing strong and compelling arguments for both sides. Some people are of the opinion that Friday’s declines were entirely an overreaction to the leave vote and it’s a great buying opportunity. There are others that have the exact opposite opinion and believe the world is falling of a cliff of some sort.

Nobody knows how Brexit will play out. It’s certainly a major change but this by no means automatically requires a major investment strategy change. My advice remains the same as it always has. Make sure you have a well-diversified portfolio1 and stay the course with your long-term investment strategy. This is the advice that has served investors best over time and I don’t believe this time is any different.

1Diversification Reminder: diversification requires multiple investments that do NOT move up and down together.

Disclosure

Market indexes performance are based on the following index funds: U.S. Large-cap Stocks: SPY; U.S. Mid-cap Stocks: IWR; U.S. Small-cap Stocks: IWM; International Developed Stocks: EFA; International Emerging Market Stocks: EEM; Real Estate: RWR; Gold: GLD; Commodities: GSG; U.S. Government Mid-term Bonds: IEF.

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