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Brexit, and How to Respond to Major Economic Events

A reader writes in, asking:

“You said on Friday that you won’t make any portfolio changes as a result of the Brexit vote. But I just don’t see how you can write it off so easily as no big deal. This seems like a very big deal to me.”

To be clear, my point on Friday was not that Brexit is “no big deal.” There’s no doubt that it is a big deal, which will have all sorts of consequences that we’ll see play out over many years.

So, to the question, “is Brexit a big deal?” the answer is a very easy “yes.”

But that’s not the question that investors need to ask themselves. The question investors need to ask is whether the results of the referendum merit a change to their portfolios.

For example, imagine that you hold shares of Vanguard Total International Stock ETF (VXUS).  The results came out Thursday evening, and when the market opened on Friday morning, the price of VXUS fell by approximately 6%. So the question a VXUS shareholder had to answer on Friday was: is a 6% price decline an overreaction or an underreaction to the economic events that had transpired?

Personally, I wouldn’t even know where to begin such a complex analysis.

But let’s imagine a hypothetical investor (Bob) who is more confident than I am. Bob decides to take a crack at assessing whether VXUS is under- or overvalued.

If his analysis is in the same rough ballpark as the overall market consensus (i.e., that international stocks as represented by the Vanguard Total International Stock ETF have declined in value by roughly 6%), then he probably shouldn’t make any changes.

But what if Bob’s analysis shows that international stocks have declined in value by 20%? If he’s even close to right — even if he’s off by several percentage points — he would likely benefit by decreasing his allocation to international stocks.

But if the market says that international stocks are worth 6% less than they were worth the day before, and Bob’s analysis shows that they’re worth 20% less, what’s the most likely explanation for that discrepancy? Unfortunately for Bob, the most likely explanation is simply that his amateur analysis isn’t very good. (After all, the alternative explanation is that his amateur analysis is on target, while the collective analysis of a huge number of true experts is way off the mark. To any outside observer, it’s obvious which explanation is more plausible.)

Even if Bob weren’t an amateur — even if he were a financial analyst or macroeconomist with relevant experience, for example — it would require an extraordinary degree of self confidence to think that his one-person analysis is probably right while the market’s analysis is wrong.

And, more broadly speaking, this is the way it goes with any economic event — even ones that are likely to go down in history as significant turning points. The event occurs, and the market reacts. And if you hope to beat a simple passive index fund strategy, you must try to determine whether the market has overreacted or underreacted. If your conclusion is close to the market’s conclusion (and you therefore make no changes to your portfolio) then you’ve simply wasted your time. And if your conclusion is very different from the market’s conclusion, then you have to consider the possibility that the discrepancy is simply because your analysis is very flawed.

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