Brexit- A Surprise?

brexit first starThe Brexit vote Thursday was a big surprise to some. As voting closed, some London bookies were putting the odds of a vote to leave at less than 10%.   Pollsters and “experts” had shown a 10 point margin 24 hours earlier for “Remain” yet “Leave” prevailed 52%-48%.   Stock markets don’t like surprises and responded with declines of 3% to 9% worldwide before markets closed for the weekend. With the flight to safety, as expected, most fixed income and some alternatives, especially gold and some managed futures, were up.

The result shouldn’t have been a surprise. We said the referendum was “too close to call” a month ago in our blog.  In large numbers, the “Leave” supporters were expressing their anger with the status quo and a desire to return to the “good old days.”  They haven’t benefited personally from globalization and now their homeland is being “taken over by immigrants.”

The issue isn’t just Britain leaving; it’s really about the future of the EU.  EU institutions have failed in a number of key areas; including lack of planning and administration relative to the integration of the various member nations and migration of people among the countries.   Now, Britain and the EU have two years to work out what could be a highly acrimonious divorce.  And, while this is happening, all across Europe countries, including Germany, France and Spain, will be holding national elections debating the question of whether sovereignty and nationalism outweighs economics.  These same issues frame the U.S. Presidential election and others around the world.

Despite Friday’s selloff, Brexit is no Lehman.  Back in 2008 after the collapse of Lehman Brothers, investors indiscriminately fled all assets connected to the American housing bubble.  Subprime mortgages had been sold to investors worldwide and panic spread like a virus.  This time, the trouble is more identifiable.  London’s ambition to be the world’s most important city is over.  The pound has lost some luster.  The EU will likely continue to splinter and perhaps disband.  If nations reject globalism and free trade, world economic growth will likely be reduced.  In 2008, central banks did not recognize nor prepare for the mounting disaster.  Today, the financial systems in the U.S. and Europe are less leveraged and better capitalized than eight years ago. Just last week, all major American banks passed the new stress test requirements.  The CBOE, Market Volatility Index, or VIX, remains far below the level of past panics.

The U.S. economy should weather the Brexit storm. American companies remain more insulated from global developments than any other country.  U.S. companies generate 70% of revenues domestically.  U.S. corporate balance sheets are strong, interest rates are low and the U.S. economy is on a pace for a 2.5% growth in the second quarter.  Consumer sentiment remains strong in the U.S., coming in at 93.5.

However, expect more volatility. Britain’s decision to leave the EU could cause more fault lines in Europe.  Elections across the globe could reverse globalization’s trend.  Chinese growth could continue to decline. There is always a list of potential fears, many of which never materialize (e.g. the “hyperinflation” predictions of 2010 due to Quantitative Easing).

Some investors have not recovered financially and/or cognitively from their losses of 2008.  They are dedicated to making sure that never happens again.  No drawdowns for them-every market blip is cause for concern. “Another collapse is coming.” This risk aversion has led them to miss a huge run-up in U.S. equities (200% since 2009) , as well as decent returns for fixed income and alternatives in the last seven years.

Certainly, one day the expansion will end and investors will feel some temporary pain.  But, trying to determine when and how that will happen is a money-losing proposition.  Maintaining a well-diversified portfolio is a better approach than having a fearful, concentrated one.  Equities, in the long run, will outperform fixed income and alternatives.  And, as we discussed in our seminar last October, the equity “premium,” obtained for taking on risk, will continue- impacted greatly by inflation and economic growth.  Lower inflation and/or lower growth, means lower equity returns.  Your risk profile determines your appropriate asset allocation and the volatility of your portfolio.

Hold on tight, the road ahead may be bumpy, but, since no one knows the future (not even the “experts” as demonstrated above), it’s the best route we have to accomplish our goals for the long term.



Diversification Means Some Leaders and Some Laggards

eggs in one basketCommon sense tell us: “Don’t put all of your eggs in one basket.” Investment professionals give it a fancier name: “Modern Portfolio Theory (MPT)”, first articulated in 1952 by Nobel Prize winner Harry Markowitz.

The concept is that, regardless of what all the financial pundits and media people say and write, we can’t predict the future. So, we spread our bets across a variety of investments. The trick, mathematically, is to consider how the price of each investment varies in relation to the others. We use the term correlation and recognize that there is a benefit to non-correlation. That is, when some are zigging, others are zagging. The objective with diversification is that for the same level of risk, we can earn higher returns and/or lower volatility.

Here’s the catch: a truly diversified portfolio will almost always have a portion of the portfolio that is underperforming. Behaviorally, all of us hate to lose. Worse yet, we often fixate on the negative, drum up feelings of regret and develop “if only” thoughts.

Let’s take a look at some leaders and laggards over the last 20 years:

Investment returns-2014_Page_1

There’s a lot of data in this chart. Click on it for a full size image. Each color represents a different asset style. Last year, the S&P 500 growth (maroon) was the top dog. MSCI EAFE (grey) was at the bottom of the list. Yet, follow the colors from year to year. Leaders one year often don’t repeat the next year. In fact, sometimes, like “chutes and ladders,” they go from top to bottom. If you have a diversified portfolio, you can be assured you’ll have some leaders and some laggards.

The key is how the elements of your portfolio work together. Let’s look at the first two months of 2015 as an example:

In January, the S&P 500 came back to earth. In fact, it was down 3%, as were small caps. International and emerging market stocks were down about 1%. So, a diversified equity portfolio in January was likely down 2%. On the other hand, a diversified fixed income portfolio was up perhaps 1-2%, and a diversified liquid alternative portfolio was up almost 2%. So, even though domestic stocks were down 3% in January, a diversified portfolio could have been close to break-even.

In February, things changed. Stocks got hot again. The S&P 500 and small caps were up almost 6%. International and emerging markets were up about 5%. Fixed income and alternatives were just about unchanged. So, a diversified portfolio might have been up 2-4% in February.

In each month there were leaders and laggards zigging and zagging. And the big leaders one month were not the same the next month. The key is the non-correlation benefits between the various holdings that can produce higher returns and/or reduce volatility.

We need to focus on the whole portfolio, not the laggards. We have to fight the bias of “fallacy of composition” which causes us to reflexively assign the attributes of one piece to the whole. In investment terms, that’s noticing one asset style doing poorly and concluding, incorrectly, that the portfolio overall is flawed.

Finally, we all suffer in some measure from the phenomenon of “if only.” The “science of regret” is quite complex. A key point is to setting appropriate benchmarks. For example, our clients know that their Investment Policy Statement (IPS) gives us our “marching orders” for managing their portfolio and includes a targeted long-term net rate of return for their portfolio. That’s the appropriate benchmark. Comparing performance results for all your investments to the top performer in the year is not only an inappropriate benchmark, but can be damaging if the result is rebalancing your allocations to chase recent performance.

Focus on diversification- use of all three asset classes: equities, fixed income, and liquid alternatives, and appropriate diversification of asset style within each asset class. You’ll have leaders and laggards. The real key is avoid our behavioral instincts to focus on the laggards and, instead, to celebrate your overall long-term performance and the fact that diversification is working for you.