How to Be Wrong: Brexit Edition

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 23, 2016 3:38:43 PM

and tagged brexit

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As an analyst and economist, I spend most of my professional life being wrong, as does everyone else in my field. No one actually expects economic projections to come true consistently; no one has the ability to predict what the market will do.

This isn't limited to economics and finance, of course. As the Harvard Law of Biology states, “Under the most rigorously controlled conditions of pressure, temperature, volume, humidity, and other variables, any experimental organism will do as it damn well pleases.” Humans are no more predictable than anything else.

That said, since we know we are often going to be wrong, we should at least plan for how to be wrong in the most constructive—or, at minimum, least damaging—ways.  

Preparing for the worst case

Much of the Brexit commentary focuses on the worst-case scenarios—a good example of a low-damage approach to possibly being wrong. After all, you could benefit from planning for a disaster, with little apparent downside if it doesn't happen. This makes a lot of sense, and it has been driving much of the reaction so far.

It's the same line of thinking that underlies the insurance industry, among others. When you buy fire insurance for your home, for instance, you are very much hoping that you will end up not needing it. At the same time, the costs of being wrong are so low that it’s still worth it.

Preparing for the most probable case

Another approach is to consider not the worst case but the most probable case. I suspect that the actual risks of Brexit are much less dramatic than the worst cases trotted out in the press. Looking at the most probable case leads to a cost-benefit analysis that is distinctly different than when you're looking at a worst case. The relevant comparison is probably rental car insurance versus house fire insurance. The second is mandatory; the first, not so much. 

The key here is the cost-benefit analysis. When you make a decision, what is the potential impact, and what is the cost of the alternative? House fire insurance may have a life-changing impact, at a manageable cost. It makes more sense to be wrong in getting it than to be wrong in not getting it. Rental car insurance (for me, at least) is usually the opposite.

Looking at Brexit, the most probable outcome is a modest overall impact, and the costs of being wrong in saying there’s no real Brexit risk seem low.

Even if Brexit happens, impact on U.S. investors may be limited

If I'm wrong, however, and an immediate Brexit did happen, two other key factors would come into play for most people reading this post: geography and time frame.  

As U.S. investors, we are primarily affected by U.S. markets and the U.S. economy. We are much less exposed to fluctuations elsewhere in the world. Although Britain is a major economy, the direct risk simply may not be that large. The same applies to Europe as a whole. In fact, if you look back to 2011 and the Grexit crisis, the contagion was limited.

It was also short term. As longer-term investors, we should be less concerned about short-lived volatility, as long as it doesn’t erode our longer-term results.Though the risks of Grexit certainly created volatility, the end result was endless negotiation and then a settlement.

For investors with a multiyear horizon, unfavorable events—Greece in 2011, the Asian financial crisis in 1998—simply don't loom that large in later years. There's no reason to believe that, even in a worst case, Brexit would be more damaging than the many other events that seemed overwhelming at the time but are now largely forgotten. Over time, the risks of being wrong don’t appear that large, especially when you consider the risks of overreacting.

The goal: be right over the long term

Right now, the issue is Brexit. Next week, it will be something different. Simply put, there are always going to be events that seem to require some form of action on the part of investors. Often, from a longer-term perspective, the best decision will be to ignore them, even at the cost of being wrong.

It's better to be wrong thoughtfully and strategically (and end up right in the long term) than try to be right in the short term and end up wrong in the long term.

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