How The Brexit Was Like Riding An ATV

This past weekend I was at the house of one of my fiancée’s relatives. They have a bit of land and we went riding on their ATVs. My fiancée and I both insisted on wearing helmets, as ATVs can be quite dangerous. The risk of not wearing a helmet is asymmetric. If you don’t wear a helmet you risk serious injury or death. On the flip side, if you do wear a helmet you don’t give up much. You don’t go faster. It’s not any more “fun”. The birds of the forest don’t sing a more beautiful song. The trees and the grass aren’t any more lush. You maybe save yourself from having a sweaty head and that’s about it. You risk a lot by not wearing a helmet and don’t save much in return.

For investors the Brexit event was similar. If you held British (or EU) stocks you were risking a lot for relatively little gain. Before the vote I saw predictions that the pound would drop from 1.45 to 1.30 versus the dollar if “Leave” won but in the event of “Remain” it might only reach 1.50. The graphic below shows one analyst's prediction and how asymmetric the risks were.

Indeed, at the very beginning of the vote tallies it looked like Remain would win, and the pound rallied a percent or two. However, once the tide shifted the pound dropped 5% (and continued falling throughout the evening).

The same with British stocks. If “Remain” won you still had a British economy being hurt by David Cameron’s renewed austerity push and a heavily indebted private sector. Likewise, with EU stocks if “Remain” won you still own companies that are domiciled in countries with a dysfunctional monetary system being hurt by the EU elite's push for austerity and balanced budgets.

We try to make investments where the risk/reward ratio is reversed. We want large upside potential and minimal downside risk. Soon after the financial crisis we invested in S&P Global (back then McGraw Hill) when the market was valuing its Standard & Poor’s credit ratings division at $0. If we were wrong and it was worthless, well, it was already valued at $0. If we were right we stood to make a lot of money. Or take our investment in Lockheed Martin (LMT) when there were fears about defense budget cuts. The market was valuing Lockheed as if cash flows were going to decline by several percent for the next decade. If we were right and the DoD shifted money from the war budget to cover other expenses, and armed conflict continued to break out in the world, eventually the defense budget would grow and we’d make a lot of money. If we were wrong, well, years of budget declines were already priced in.

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