There’s really no nice way of putting it. Friday was not a fun day for the majority of investors after the Brexit vote.
Following Britain’s decision to leave the European Union after a more than 30-year marriage, the S&P 500 index fell 3.59%, while European markets collectively suffered declines in excess of 11%.
The fallout from Brexit simultaneously illustrates two realities of investing:
- The interconnected nature of modern global stock markets
- The importance of genuine and broad diversification
While the majority of investors experienced losses on Friday, very few who were properly diversified suffered anything close to a double digit decline. Only those making narrow, concentrated bets felt that kind of pain.
More importantly, for an investor whose risk profile dictates owning a portfolio with less than 100% stocks (which is the case for the majority of investors), several asset classes they likely own went up on Friday. This list included US treasury bonds, TIPS, and international bonds.
For investors with an appropriate asset allocation and a broadly diversified portfolio, Friday was a perfect example of why it’s a bad idea to judge your investments against the commonly reported stock benchmarks (such as the Dow Jones Industrial Average, the S&P 500, or the FTSE).
If you do this, when markets go down you’re going to think your portfolio lost far more than it actually did. On the other hand, when markets go up you’re going to expect returns for risks you didn’t take.
Neither is good for your psyche.
Don’t Miss the Forest for the Trees
With all of that said, on days like Friday the single most important word for us to lean on as investors is perspective.
It’s rarely ever as bad (or as good) as it seems in the heat of the moment.
Getting to the heart of this post, we also need to avoid the risk of missing the forest for the trees. While the financial news media would have us think that the world is coming to an end following Brexit, Friday was simply one day in an incredibly long investment history.
In other words, it was simply one tree within a gigantic forest.
Zooming Out for Perspective
To help illustrate this, let’s take a look at the history of the S&P 500. The first chart below shows the performance of the index for the five trading days last week:
Not surprisingly the decline on Friday is both obvious and, apparently, quite significant.
The same is true for the last month:
However, when we look at the year-to-date chart, we start to see that while Friday’s losses weren’t fun, the declines essentially just rolled back the clock to the middle of May:
Zooming out to a one year chart, it’s now pretty clear that just in the last 12 months we’ve experienced several ups and downs of equal or greater magnitude than what we witnessed on Friday:
However, even one year of returns represents just a handful of trees within what is a really large forest. Let’s zoom out further by taking a look at the five year and 10 year charts below:
While we can see Friday’s decline in the chart, you’d be hard-pressed to describe it as anything different than many other short periods of time since 2006.
Finally, if we really want to see just how tiny of a blip Friday was on the radar, let’s look at the logarithmic charts dating back to 1990 and then even further back to 1950:
As the charts help us to see, the reliable wealth building power that comes from diversified investing means that short-term declines are outweighed handily by long-term returns.
On the Temptation to Respond
Over the coming days, weeks, and months, we’re going to hear an almost endless barrage of “what to do now” and “how to protect yourself after Brexit” on TV and in print media.
It can be tempting to want to “do something” in response.
However, shooting from the hip in following market events is never a good idea. Instead, we need to ask ourselves a few simple questions:
- Have I properly evaluated my willingness, ability, and need to take risk as an investor?
- Does my portfolio align with my risk profile? Is my asset allocation appropriate for my risk tolerance?
- Do I have a written investment policy statement that outlines these things and illustrates why my portfolio is appropriate for me?
If the above is true, then the best approach is the same as it has always been: Remain disciplined with your asset allocation, monitor regularly and rebalance when appropriate, and make changes to your portfolio only in response to your own path towards your goals.
On the other hand, if the above is not true, there’s no better time than now to review your risk profile and properly align your portfolio accordingly.
Whether markets go up or down from here is anyone’s guess. However, with the wrong asset allocation it’s a virtual certainty that you’ll be unhappy with the outcome.
Either because your portfolio is more risky than you’re comfortable with or because you’re invested too conservatively and won’t benefit enough from the growth of stocks to reach your goals.