Last week, the UK held a referendum on whether or not to leave the European Union. Setting aside the whole issue of whether or not that was a good idea (I don’t know) or the value of referendums, I learned an investment-related lesson watching the markets react to the surprising news.
I started watching after the voting was complete, but before the count started coming in. I was curious to see what the most likely outcome was, so I looked at polls and the prediction market. The poll that I saw showed that Remain was ahead by 1%, but there was also about 9% undecided. My assumption (erroneous, in hindsight) was that the undecided would be more conservative and would swing toward Remain. The prediction markets made me feel more confident in my assumption. They assigned a probability of approximately 60% to Remain and 40% to Leave. In reality, 6 in 10 isn’t great odds.
Looking at the currency market, after the voting closed but before the results had started to come in, the pound almost immediately began to fall against the US dollar. Either someone (smarter than me) knew something, or nervousness pushed traders to sell off the now-riskier GBP. My conversation with a friend (for your entertainment):
Him “Are you going to bet the farm on the a Remain vote and buy a ton of Pounds?”
Me “I actually would bet on remain. But I don’t think it’s a slam dunk.” Full disclosure: I didn’t bet any money on the outcome.
Him “I think half the results are in and it’s 51.3% leave. Pound is down 14 cents against the dollar. Could it go down 50?”
Me “That’s nuts. It’s hard to believe leave is ahead. The pound could take a serious beating.”
Him “GOOD THING YOU DIDN’T BET THE FARM ON THE POUND”
It’s easy to be overconfident when you have nothing riding on the outcome of a prediction. It made no difference whether I was right or wrong, so I underestimated the uncertainty.
Uncertainty means more than just not knowing the outcome beforehand. Before the vote was counted, we didn’t know which side would win, especially with the polls so close. But uncertainty also means an elevated chance of being wrong. And even with polls that show more concentrated support (eg. Clinton over Trump), there is still the possibility of being wrong (eg. Alberta provincial election 2012).
There is also an asymmetry to the potential outcomes. If Remain had won, the market would have continued it’s slow, positive climb. If Leave had won (as it did), the market would quickly fall (as the UK market did). This is actually typical of the market more generally. Over months and years, it tends to climb slowly, with short period of sharp, quick declines. Because people are generally optimistic and because companies work hard to produce consistent, positive results, the market value of shares climbs slowly over time. There is not much risk of a quick, positive price spike in mature companies. (If it happens, it’s often the result of a miner discovering a large deposit or an innovative manufacturer making a new discovery.)
Because of the market asymmetry and the asymmetry in the expectations for the Brexit outcome in particular, the best strategy, no matter which outcome I thought was more likely, would have been to make a small bet that paid off in the case that Leave won. For example, I could have bought a put option that would allow me to sell the UK index near the current price. If the market rose, I’d lose my small premium. If the market fell (and it tends to fall more aggressively than it rises), I’d get a payoff.
This isn’t a good strategy to follow month-to-month or year-to-year, because it will lead to a “death by a thousand cuts.” It’s also really hard to implement because it requires being constantly pessimistic (which seems to go against human nature) and it will be wrong most of the time (people hate being wrong). But when a big, influential event is on the horizon, or when markets are nervous (elevated volatility) for any reason, this asymmetrical bet on the negative outcome could pay off nicely.