Investors should keep calm and carry on

published 18 August 2017

858-rain-634 — How prepared should you be for the future storms?

With US president Donald Trump and North Korea's Kim Jong-un at loggerheads, markets are struggling to price in potential nuclear confrontation. So what can past periods of conflict teach investors about dealing with geopolitical strife? The closest parallel in terms of the stakes (a nuclear confrontation, rather than a "conventional" war) is perhaps the Cuban Missile Crisis, which barely rattled stockmarkets.

However, as we explain below, there are big differences between markets then and now, which may have accounted for some of the sang-froid shown by investors. That said, various studies of past crises tend to show that market reactions are varied, and generally short-lived.

As Ben Carlson noted recently on Bloomberg View, in the six months after World War I broke out, the Dow Jones index fell by more than 30%. But in the following year, it rose by nearly 90%. From the start of the war to the end, the Dow made an annual 8.7% gain. It was a similar story for World War II (the annual gain was around 7%).

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Even where a geopolitical event coincides with a large stockmarket reaction such as when oil cartel Opec announced an oil embargo during the Yom Kippur war in October 1973 this typically occurred during a time of recession. Even the September 11th 2001 terrorist attacks, which provoked a double-digit fall in the Dow on the day, had little lasting impact on shares. Instead it was the ongoing fallout from the collapse of the tech bubble that had the real impact on markets and the broader economy.

So if there's any lesson from history, it's the uncertainty that markets hate, rather than geopolitical disruption itself. Of course, there is always uncertainty in markets but investors seem to find it particularly difficult to discount the range of potential outcomes when politics or conflict rear their heads. As a result, the jitters in the run-up to geopolitical crises or the outbreak of war are often far greater than anything seen once the situation has crystallised.

That doesn't mean that we can ignore what's going on, particularly when the consequences are potentially so severe. But it does suggest that you shouldn't make any panicky adjustments to your portfolio in reaction to global events. Overall, we'd recommend holding 5%-10% of your portfolio in physical gold (actual bullion or exchange-traded funds, depending on how concerned you are). But that's an asset-allocation decision (gold can act as a useful form of insurance for your portfolio, with its tendency to rise when other assets fall), rather than a specific response to current geopolitical turbulence.

How markets reacted to the Cuban Missile Crisis

Throughout the summer and autumn of 1962, tensions mounted between the US (under president John F Kennedy) and the Soviet Union (under Nikita Khrushchev) over a Russian attempt to position nuclear weapons in Cuba. The crisis came to a head over 13 days in late October, as Kennedy issued an ultimatum to Krushchev and the world reached the brink of all-out nuclear war. The reaction of the S&P 500? During the week of 22 October, as the crisis was building to a peak, the S&P lost less than 1%. After the Russians backed down, it rose by 3.5% over two days. In short, if you'd looked at the price of the S&P alone, you'd never have guessed that the world had come within sniffing distance of Armageddon.

Arguments that this was down to the foresight of investors ring hollow, given the widespread sense of impending doom documented by most contemporaneous observers. What's probably more significant is that stocks had already fallen sharply in early 1962, in what was known as the "Kennedy slide". Between December 1961 and June 1962, the S&P 500 fell by more than 22% (this included a "flash crash" on 28 May, when the Dow Jones lost nearly 6% in a single day). So by the time October rolled around, stocks had already endured a bear market (defined as a decline of 20% from a previous high).

And contrary to what you might expect, this slump had little to do with geopolitics. In another somewhat ironic foreshadowing of today's Trump administration, it was a lot more to do with Kennedy's hamfisted attempts to use the White House as a bully pulpit to force the US steel industry into cutting prices (with the aim of lowering costs for industry and boosting the economy).

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.