Exogenous Shock

That is the term used by professors of finance to describe “an event outside the economic system that affects its course.”  Just last week, we experienced one.

The great people of Britain voted on whether they should remain as members of the European Union (EU).  As everyone is undoubtedly aware, a majority of Britons expressed dissatisfaction with their entangling European alliance and chose instead to take a walk on the wild side.  Great Britain will be going it alone.  Not surprisingly, most Brits want to have a more sovereign nation with greater control over borders and trade policies.  However, by making that choice, the nation will probably become a marginally less prosperous one due to the loss of its favorable trade arrangements within Europe under the current system.  Will this exogenous shock have a lasting impact on the global economic system, or is it merely a temporary blip?

It is too early to tell.  If it turns out that Brexit is just the first step in the complete unraveling of the EU, the effect on global output and trade will almost certainly be negative. 

However, if the rest of Europe manages to keep it together, it is possible the EU will actually become stronger without Great Britain as a member.  Having never adopted the Euro currency, the British have been somewhat reluctant participants in the EU experiment from the beginning.  Without the British holding them back, the remaining members of the EU may very well push forward and increase coordination of capital markets within Europe.  That would be a big boost for the financial powerhouses of Germany, France, and the Netherlands.

The uncertain consequences of events such as the Brexit are the reason investors must remain focused on the long run and maintain a properly diversified portfolio.  By spreading risk over various asset classes and individual investments, we can reduce the overall risk of loss in a portfolio caused by exogenous shocks.

Frederick Maxted                                                                                                                                                                                                                                    1 October 2016