So far I have managed to stay completely silent on the topic of Brexit, at least on this blog. However, I have been asked many times if I have a secret investment plan for surviving and even thriving in the event that the UK votes to leave the EU.
Since we now have just such a vote I thought it would be remiss of me not to say a few words, although I will be sticking purely to my secret investment plan and not wandering into the murky world of politics.
I’ll work through each of the major points in turn and then reveal my secret plan.
Point 1: A vote to leave the EU means more uncertainty
I think it would be difficult to argue against this point, in the short to medium-term at least.
Although the long-term uncertainty around both the Remain and Leave outcomes is probably about the same, i.e. nobody has the faintest idea how the world will look 10, 20 or 30 years from now, I think we can safely say that over the next few years, the future of the UK economy just got a whole lot more uncertain.
Point 2: The future was, is, and always will be, uncertain
The fact that the future is uncertain, Brexit or not, should not exactly come as a big surprise to most investors. Investing is after all the art of trying to take on a degree of uncertainty in a profitable manner.
There are several key uncertainties which are always true and which investors should never forget:
- The future of any single company is highly uncertain
- The future of any single industry is highly uncertain
- The future of any single country is highly uncertain
- The future of the stock market is highly uncertain
The vote to leave the EU has made people much more aware of that third uncertainty than usual, but the point is that these risks and uncertainties are always there, whether we are aware of them or not.
In my opinion, Brexit is just another risk in the unending sequence of risks which investors have to face up to. As such I don’t think it’s sensible for investors to have any special plans for Brexit, or any other specific event.
Instead, I think they should follow a simple plan which is designed to keep risks and uncertainties to acceptable levels at all times, regardless of what events may or may not occur in the future.
Point 3: Diversification is by far the best defence against uncertainty
From an investment point of view my preferred method for dealing with these uncertainties is to stay widely diversified across each dimension:
- Avoid being over-exposed to any one company
- Avoid being over-exposed to any one industry
- Avoid being over-exposed to any one country
- Avoid being over-exposed to the stock market
Since the underlying risks are always and forever present I think each of these risk avoidance strategies should be used at all times and in a consistent manner, regardless of whether the market or the economy is up or down, volatile or calm.
Here’s how I think about each of these dimensions of risk in turn:
Controlling company-specific risk – This one is fairly simple. Just set a limit on the maximum you’re willing to have invested in any one company, as a percentage of your overall portfolio.
Controlling industry-specific risk – There are two aspects to this one. First, what does “industry” mean and second, how can we control exposure to each of them?
On the first point, there are at least a couple of different industry classification systems, but the definitions I use come from the Industry Classification Benchmark (ICB), which is the system used by FTSE. I focus on controlling exposure to any one of the ICB sectors rather than industries, as Sector provides a more appropriate degree of granularity in my opinion.
You can find the ICB Sectors for UK-listed companies on various websites such as the London Stock Exchange (where the ICB sectors are called FTSE sectors), SharePad and others.
On the second point of controlling sector/industrial exposure, there are two main routes. Keep track of your exposure to each sector as a percentage of your overall portfolio and then put a limit on how much you’ll have in any one sector or, more simply, put a limit on how many stocks you’ll have from any one sector.
Controlling country-specific risk – The easiest way I’ve found to do this is to jot down the percentage of revenues and/or profits each of your holdings generates from the UK (or whatever region you’re most likely to be over-exposed to). Then just put a cap on the average exposure you’re willing to take across all holdings in your portfolio.
Controlling stock market risk – Not everybody wants to be 100% invested in the stock market because it’s too risky for them. The answer is usually to have some portion of your portfolio in other volatile asset classes (usually via some sort of ETF or similar) such as bonds, commodities, property and so on. Alternatively, you could hold the non-equity portion of your portfolio in non-volatile assets or cash.
Here’s how I think about how much of an overall portfolio an investor might want to have in equities:
First of all, as a rough rule of thumb, you should expect to see equity markets drop by at least 50% on several occasions during the typical investment lifetime of a decade or three.
You should then think about how much of a drop in the value of your portfolio you could stand before panic-selling and making a dash for the apparent safety of cash.
For example, if the biggest peak-to-trough decline you can stand is 20% (which would indicate that you’re a relatively risk-averse investor) then it would probably be a good idea to have no more than 40% of your portfolio in equities or other volatile assets.
That’s because a 50% decline in the value of your equities (which make up 40% of your portfolio) would produce a 20% decline in the value of your portfolio as a whole.
So in a really bad 50% bear market, you’d only see a 20% decline, assuming that the remaining 60% of your portfolio was in cash or some other fixed or non-volatile investment.
An investor who could stomach a 40% decline would have to limit their stock market exposure to 80% and so on.
My secret Brexit investment plan: Keep calm and carry on
By now it should be fairly clear that there is no secret Brexit investment plan.
Like most investors, I am not as clever as George Soros and I have no ability to stay “ahead” of the market by shorting the pound or the FTSE 100 or moving into this, that or the other sector which may or may not suffer/surge in the post-Brexit boom/bust.
Instead, I use a simple diversification policy which I will not be changing one jot because of the UK’s decision to exit the EU.
That simple diversification policy follows on from the four key uncertainties mentioned above and is designed (along with a collection of other rules) to produce a portfolio which generates higher returns than the FTSE All-Share whilst also being less risky:
- Don’t have more than 6% of the portfolio invested in any one company (which means holding 30 companies most of the time)
- Don’t have more than 10% of the portfolio invested in any one industry or sector (i.e. three out of those 30 holdings)
- Don’t have more than half of the portfolio’s aggregate revenues (or profits) coming from the UK
- Stay 100% invested in equities at all times (since I know that personally I can just about stomach a 50% decline in the value of my portfolio)
Those rules are calibrated to my personal risk tolerance, so if you choose to avoid being over-exposed to companies, industries, countries and equities then you may well decide to use slightly different rules to those listed above.
For example:
- If you are more of a risk seeker then you might choose to hold 20 companies instead of 30, with a maximum of 10% per company instead of 6%.
- If you are more risk averse you might choose to have, say, no more than 50% in equities, with the rest in cash or other fixed investments.
However, the basic idea of always being widely diversified across multiple dimensions of risk is still a very good one, especially for stock pickers.
At the very least it is, for most investors, a far more sensible way to cope with the uncertainties of Brexit than any quick-footed attempt to either avoid losses or make a quick profit.
“Avoid being over-exposed to the stock market”
“Stay 100% invested in equities at all times”
Sense a little dichotomy creeping in here?
Suspect we are missing a basic tenet of the Investment Plan?
Hi Magneto, thanks for pointing that out. I’ve edited the article now so it should make more sense. Let me know if it still doesn’t.
As always some great very sound thoughts here John and much like my thinking.
“However, I have been asked many times if I have a secret investment plan for surviving and even thriving in the event that the UK voted to leave the EU.” My secret investment plan is the same as the one prior. A diversified (asset type and country) portfolio with mechanical preset rebalancing bands. The result this week was a portfolio that was up 1.9%.
Hi RIT, good to hear from you and good to see that your widely diversified portfolio was up this week.
Given the ease with which investors can access the global economy it seems crazy not to do so, especially given how most people have country-specific risk in where they live and country and industry-specific risk in where they work.
After all, having a “nest egg” is as much an insurance policy against uncertainty as it is a mechanism for making paid work optional.
Dear John
Thank you for another great post but I am sorry you did not “wander in to the murky world of politics”. This is regardless of your stance on what happened last Thursday.
The result as Friday was was far bigger than any share portfolio and has left me traumatised, depressed, disgusted and outraged at was been done to the country I once loved. Further I am absolutely petrified/terrified for the future of the U.K. economy. I think nobody has faced up to the reality of a. by how much our sales to the EU will decline over any reasonable time frame you want to consider; b. by how little we will be able to grow our exports to countries outside the EU which was held as the promised land by leave campaigners. This was one of the lies made that has not really been picked up on; c. the brain drain that will occur over the next five to ten years that will slowly erode away at the productive capacity of the country. (on that front my cousin who is a gynaecologist is looking into this and I, while my brain may not be much of a drain, will be looking to emigrate to an EU country and failing that, I have Singaporean wife).
I have not been investing that long. I inherited £150k from my mother in 2008 but used all that to get my business through the financial crisis. My company did not pay me back in full until around 2012. I have done ok (IMO) (at investing and the business, though now to all intents and purposes worthless, has done well as well) and think I have a reasonable aptitude for investing though I am no Warren Buffett!
But now I am considering selling the entire portfolio and either investing in non English funds and/or non English government bonds. For two reasons I simply do not have the energy and it seems so pointless to fiddle around with a stock portfolio worth a few thousand pounds when your country is going down the swanny. Secondly, I would never back this country, it does not deserve it and short, medium or long term if BoJo, Gove and Farage get their way it does not have a future. It will make the sixties and seventies look like paradise.
Sorry to go so off piste.
Kind regards
Michael
Hi Michael, to be honest there isn’t a great deal I can say on this matter, which is why I haven’t.
My opinion is that the future is a very murky place and I for one have no ability to forecast what will happen over the next few decades, which would have been true regardless of the referendum result.
All I can do is roll up my sleeves and get on with the job of doing the best I can in whatever world I find myself in.
In terms of investing, as long as I have access to a wide range of globally active companies then I’m happy to invest in them which, if the UK does go down the swanny, seems like a reasonable way to offset some of that country-specific risk.
Michael, You seem overly and perhaps unnecessarily anxious about Britain’s trade with the declining EU block. The reality is that Germany and France contribute most of the EU’s exports to the UK. Germany has 34% of it’s EU trade with the UK and it’s the most profitable by far. In fact the UK is the 2nd biggest trade export for Germany and it’s bigger than China which is loss making for Germany.
The UK has to do nothing, to put the onus on Germany to simply tell the EU (which Merkel is already hinting at) to do nothing to upset these trade arrangements.
This is the single biggest respectful achievement the UK could have done in the last century and one that will allow Britain to stand tall and achieve direct trade arrangements with 80% of the non-EU world without political-fiscal or legal interference.
The EU will start to unravel in time as do all anti-democratic organisations. Most of the rest of the world is growing faster then the EU and most of the rest of the world’s countries have traded more successfully with the EU than those 27 countries that are shackled within it.
I wouldn’t sell all your shares — it could be a big mistake. Like John says — all of these things balance out over time.
Hi LR
I completely agree. The whole “free movement of capital”, “free movement of labour” etc is a mantra peddled by the zealots from Brussels.
Will the US or Canada in their trade agreements have to contribute to the bloated bureaucracy in Brussels or accept free movement of labour – or be subsidiary to EU laws in their countries – of course not – and neither should we. We should accept nothing less than a normal free trade agreement with EU as if we were another country completely outside Europe.
People bleat on about the subsidies for farmers – but its only our money coming back; even after the rebate we only get back about half of what we put in
If we cant agree a normal trade deal, we will have to revert to normal WTO terms with tariffs on both sides – and as you say I cant see Germany being very keen on that
My only hope is that the next Conservative leader is tough enough to face Brussels down for the undemocratic self serving group of elitist bureaucrats they are
as for the city – I personally would not worry about them. I remember the days when we were told that the country and the city would collapse if we did not join the Euro.
there are lots of very bright ambitious people in the City; they will figure out a way to make money – in or out of the EU
the only hope for the rest of Europe is that Brexit will provoke a change of course for Brussels – but I doubt it
My plan is always to be invested in international equities not only n UK equities, or alternatively in a large number of companies which have earnings from outside the UK. For example owning HSBC instead of Llloyds bank.
Before the vote I was pretty sure leave would win based on online comments on the BBC and conversations with people I met in places like pubs and doctor’s waiting rooms. The markets however were reflecting a certainty of a remain victory, which I put down to City types not getting out of London much. This meant very little upside if I was wrong but huge downside if I was right, so I sold off my homebuilder and banking stocks. I chose those stocks as they were most sensitive to a Brexit based on logical analysis. Also there was a scare about a week before the vote when a poll showed Brexit ahead and I took note of which stocks reacted badly.
Hi Andrew, yes it did look like the market misjudged the result. Even a hedge fund’s supercomputer is no substitute for a crystal ball.
Having been an investor for about 45 years I have weathered a lot of storms that looked terrible at the time, but seem like minor glitches with the benefit of hindsight. I believe that John’s plan to keep calm and carry on is absolutely right. High quality companies that produce a high level of return on capital invested will continue to do well. A much greater concern than Brexit is that many of the drivers of economic growth, such as the emergence of new economies, more women in the workforce, falling barriers to global trade and new technologies that that help companies to transcend national boundaries are slowing down and may even reverse. We may rely much more on dividend income than on growth in the future.
Hi KenN, good point. The global economy has seen a lot of one-off tail winds these past few decades and we will need a few more one-offs to keep up that historic growth rate, otherwise – as you say – dividends will become all the more important.
Pay no heed to RIT: he’s heavily invested in Australia, ignoring the fact that Western Australia voted to leave the Federation in the thirties. 🙂
Hi dearieme, I thought RIT had sold his Oz positions as he was headed to the Med instead?
Knowing RIT, I’m sure he has such trifles as risk management well under control.
Well here we are on the Monday morning after, and looking at our portfolio, not a lot seems to have shifted over the last 6 trading days, to justify major changes !
The big loser seems to be sterling, but that results in International positions showing illusionary gains !
But then all we can do I suppose is to work in £Sterling as regards rebalancing or buy/sell strategies ?
We have accordingly pared back on International just a trifle, and added to Commodities which seem to have over-reacted and may now be over-sold ?
Any views on Commodity company valuations ?
Early days really.
Pleased to see site relatively free of gnashing teeth and hype.
Hi Magneto, yes some things are up, others are down and the future is uncertain. So it’s business as usual for the most part.
Regarding commodities, I don’t have a general view but I do own a few. The ones I own (big FTSE 100 companies) have jumped all over the place these last few days, but are not obviously on the way down; in fact one of them has started moving upwards recently.
In my portfolio it has been the UK retailers that came off worst, but I’m wary of piling into that area because I don’t want to be over-exposed either to the UK or retailers, which is of course the theme of the original blog post.
The thing is we all gone to sleep on Thrusday a bit richer and we woke up on Friday about 10% poorer.
The problem we have is that Brexit has divided British people in two. Not only this, but political parties are in a complete meltdown.
Negociating a deal with EU is by no means easy and we certainly need a strong Government, not a weak one. It is unlikely we will have a good deal with EU, and I do not think we will have one in 2 years. The average treaty signed by EU takes about 5 years to get it done.
The 2 years period is not writen in stone, it could be extended. Even if 2 years period is not extended, there could be some temporary meassures in place.
There is a downside to this: there will be less investment in the UK economy, increasing negative current account, low productivity and devaluation of Sterling. This is a known cycle for the UK economy from 1960 to 2000, where Sterling devalued against Deutsche Mark continuosly and the German response was to make better products (including cars) and increase productivity.
In terms of investments I have always saud to have a well diversified Global portfolio. There are better companies accross the pond (in US) and should US avoid electing a populist President, the US economy will feel a positive effect as a result of Brexit.
My opinions.
Hi Eugen, yes I agree with just about all of that. As for the US having better companies I can’t really comment as I don’t look at US stocks, but investing globally and avoiding excessive exposure to the UK economy was always a sensible move.