Brexit investing strategy: tips from an expert

Guest author Lars Kroijer explains how your investment strategy should shift during Brexit.

The unexpected result of the UK/EU referendum in 2016 sent shockwaves across the world, and gave rise to many dire warnings about future outcomes.

But does this extend to the markets? In the current context Brexit is both a political certainty and a mass of confusion – as recent chaotic events in the election have proved.

Should we change our investment strategy as a result?

In short the answer is yes, but perhaps not how you think.

What can we expect?

It is highly unlikely that the vast majority of investors will be able to beat the markets themselves, either through active stock selection, market timing, or by picking the one-in-ten active investment funds that may do so over a ten-year period.

For your equity exposure, you should pick as broad and cheap an index tracking exposure as you can get your hands on, namely a world equity index tracker. This is no less true ‘just’ because the UK public decided to leave the EU.

You most likely couldn’t beat the markets before the referendum, and you most likely still can’t.

For more detail, my short YouTube video outlines this argument:

What you perhaps can expect is to make 4–5% above inflation, compounding over the long run. This projection is based on over 200 years’ history of global equity returns. And you can expect that return to range from lottery-type surprise winnings to desperate failures.

Also, you can reasonably expect to be compensated in higher risk periods with commensurate higher expected returns: but there are obviously no guarantees.

So, if we haven’t found a crystal ball to guide us in a post-Brexit world, what can we do? There are two main things we should focus on.

1. Evaluate whether the risk of the markets has changed enough that we should re-evaluate the risk levels of our portfolio.
2.  Consider whether the sudden change in the political landscape has changed our overall economic life enough that our risk profile should change as a result.

Market risk

Below is a graph of the expected future risk of the UK stock market (‘Estimated Future Risk of UK Equities’).

Without being too technical it measures the expected standard deviation at various points into the future. Since the index value is based on the implied volatility of equity options it is a market price. If you think you know the future volatility of the market better than this chart you can get rich trading it (many try!).

There are many issues with this kind of chart, including that the value itself is very volatile (so the risk changes a lot), that the volatility doesn’t capture ‘fat tails’ (the fact that unlikely events happen far more than predicted by the normal distribution assumption of the standard deviation), and that it reaches only up to a year into the future.

Having said all that, the chart does give a good idea of future expected risk (Google ‘FTSE implied volatility index’ for more on this).

But what we see from the chart is that as momentous as the Brexit vote undoubtedly was politically, in terms of market risk it hardly made a dent (see the very volatile 2008/09 period circled in red compared to the more recent period).

Because the Brexit vote was a genuine surprise (the Betfair probability of Brexit was about 15% on the day of the referendum) we can get a good sense of how much things shifted as a direct result of the vote (if Brexit had been expected to win, the impact would already have been built into the market price), and the answer is that the equity market risk hardly moved.

Confused? Don’t be – but know that the expected risk of the stock market in the future did not change as a result of Brexit (other than experiencing a short-term bump right after the referendum), and therefore that alone should probably not cause you to change the risk profile of your investment portfolio.

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Your own risk

But while the market risk has not changed, your personal risk may well have.

Although the overall market did not move hugely after the Brexit vote there are clearly some sectors and geographies that will be hugely impacted by the referendum result. If you work at a UK company that exports most of its products to Germany then a Remain vote would clearly have been better news, and you need to understand how Brexit will impact your overall life.

Similarly, imagine a scenario where you work in mid-level management at a UK pharma business with major exports to the EU. Confident in the company, you have invested most of your savings in company stock, your pension is guaranteed by the company, and most people in the town you live in are also employed by the same company.

Now imagine you wake up one morning to news that Brexit negotiations are going horribly and senior EU officials are saying specifically: “since the UK is no longer in the Union we no longer want to be dependent on their pharmaceuticals and will initiate a major programme to erect barriers to UK exporters and to support EU-based competitors”.

Hell breaks loose at your company. Your pharma company stock is down 50% and people start talking about the need to shut UK operations and the risk of the corporation defaulting on its loans.

Basically, your whole economic life has been turned upside down because of adverse Brexit negotiations.

To say you are overexposed to your pharma company would be a massive understatement.

Your job, pension, savings, and house all hugely correlate to the company’s fortunes. You were clearly guilty of putting all your eggs in the pharma company basket and are now paying for it. Even less extreme versions of this example are well worth avoiding.

How to avoid pharma-geddon

So how do you know if sectors you are exposed to might be helped or hurt by Brexit?

Again, because the Brexit vote was a surprise we can see the market impact right after the referendum. If the EU official’s pharma rant had been before the election you would expect your pharma stock to be down a lot right after the election – that’s how you know.

So my advice? Sniff around. Understand your economic exposures and see how those sectors fared after the vote. Then see how much reports of progress in the Brexit negotiations move things for the company and other factors you are exposed to.

If your investment portfolio consisted of a world equity tracker combined with super low risk government bonds, then you would broadly have diversified away a lot of the sector/company specific Brexit risk.

But like our pharma example above, your individual non-portfolio exposures may still lead you to change the risk you feel you can afford in your investment portfolio.

As an example, illustrated below, you may previously have had the fairly bullish 75%/25% equity/bond split, but after assessing your new ‘Brexit adjusted’ risk, feel like a 50%/50% risk is more appropriate.

Not because the markets have gone down in value or up in risk. But rather because the sectors or geographies you are otherwise exposure to changed your overall risk profile.

Deciding how Brexit might impact your overall economic life is far from a science. We don’t really know and can’t expect to be precise about it. But you shouldn’t ignore the issue, particularly with something as potentially impactful as Brexit is likely to be.

Take a longer-term view

Another potential change caused by Brexit to the simple, cheap, and sensible portfolio above could be the currency you hold your cash/government bonds in.

A potential consequence of Brexit is a change in the likelihood of retiring, or otherwise needing your savings in Euros. You may have planned to retire in Spain and thus should have part of your savings in Euros to avoid the currency risk between your savings in the UK and eventual cash need.

But with Brexit it could be that the likelihood of retiring or otherwise needing your money on the continent has declined, and as a consequence you should reduce your holding in the Euro currency.

If you are uncertain about your overall exposure, or the best currency for low risk holdings, perhaps consider consulting a financial advisor to help you think through your circumstances. When hiring someone, make sure you don’t start paying them to actively outperform the market.

Just as you probably can’t do that yourself, they are likewise extremely unlikely to be able to outperform it. But they can help you with understanding your overall economic life, how your risk profile may have changed, or even how you can protect yourself from being the mid-level pharma manager in the example above.

Stay tuned

It feels odd that something can dominate the news as the Brexit process does and yet we are still unable to find a different perspective to that of the overall market.

But do think about how Brexit will impact your job, sector, house, pension, insurance policies, and other things that contribute to your overall economic welfare. Be open to reconsidering the risk of your portfolio as a result.

Lars Kroijer is the author of Investing Demystified – How To Invest Without Speculation and Sleepless Nights' . He founded and ran Holte Capital, a London-based hedge fund, in 2002. You can follow him on @larskroijer.

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