Resist Fight-Or-Flight Response in Wake of Brexit Vote

Britain's Thursday vote to leave the European Union sent shock waves through financial markets. The British pound plunged, as did the U.S. stock market when the trading day dawned. On the positive side of the ledger, gold soared and U.S. Treasuries were poised for a very good day on Friday.

Such gyrations can spark a "fight or flight" response in investors, a desire to take action of some kind. "Fighters" might be inclined to go bargain-hunting amid the chaos. On Friday morning, for example, I got an email from a friend asking if I thought it was a good time for her to deploy her long-held cash stake into stocks. Other investors view extreme market volatility as an invitation to flee—to retreat to the security of cash until the turmoil blows over.

Yet extreme market volatility is almost never a good time to take extreme measures with your portfolio—whether aggressive maneuvers or defensive ones. There's no telling whether the shock of the Brexit vote will mark the nadir for global stock markets in the near term. Thus, while bargain-hunting amid the chaos can be reasonable for investors with long time horizons, such investors are better off being deliberate about it, doing their homework, picking their spots, and putting the money to work over a period of weeks rather than all in one go. Yes, they may leave money on the table if stocks head off to the races after digesting the Brexit news, but I suspect we'll see more dips for stocks between now and year-end. And in any case, it's always better to be an investor than a speculator.

Nor do defensively minded investors frequently time things right by retreating to cash. The investor who pulls out of stocks and other plunging assets does buy some short-term solace if the markets continue to be chaotic, but that sense of peace could prove short-lived when stocks recover. When that happens, what had been a sense of calm is usually replaced with the nagging worry about when to get back in, and that can be awfully hard to gauge. To this day, I'm receiving notes from investors who got defensive during the 2008 financial crisis and still haven't fully deployed their cash.

Yet as sensible as the adage "Don't just do something, stand there!" is, doing nothing can engender a sense of helplessness. As you think about your portfolio today, here are some steps you can take to ensure that you stay on the right track.

Say It With Me: 'What Matters Is My Risk Capacity' Most investors have been inculcated in the virtue of gauging their risk tolerance; when recommending stock/bond mixes, many financial services firms have long used investors' self-assessments of their ability to handle losses psychologically. Yet the really important concept is risk capacity--what sort of losses can an investor endure without having to rework a goal?

Investors with a still-long runway to retirement--say, 10 years or more--have fairly high risk capacities. That means that regardless of how they feel about near-term losses, they're likely to recover from them during their time horizons. For that reason, such investors ought to have aggressively positioned portfolios with at least 50% in stocks; given today's low bond and cash yields, a more conservatively positioned portfolio will barely preserve purchasing power, let alone grow.

Meanwhile, investors who are closing in on retirement or already retired have lower risk capacities. Even if they've been comfy with high equity weightings throughout their investing careers, having a too-aggressive equity weighting in retirement can lead to catastrophic losses that would have real implications for their portfolio plans. A soon-to-retire investor who sees her portfolio take a big drop may need to delay retirement, for example, while an already-retired person with big portfolio losses may be forced to give her portfolio withdrawals a big haircut. For too-aggressive investors closing in on needing their money, market drops should actually be a wake-up call to find their way to a more situation-appropriate portfolio mix.

This article does a deeper dive into the crucial concept of risk capacity, while my model portfolios provide some age-appropriate portfolio mixes for investors at various life stages.

Assess Liquid Reserves While plowing a bunch of money into cash during volatile markets is rarely advisable, that's not to say you shouldn't have some liquid reserves on hand as a matter of course. Thus, tough markets can be a good time to check the viability of your cash holdings. (Don't count residual cash holdings in your mutual funds, because you couldn't get access to that money if you wanted it.)

Yes, cash yields next to nothing today. But if you're getting close to or in retirement, holding a cash cushion consisting of six months' to two years' worth of living expenses can help ensure that you can cover your household's expenses without having to invade depressed assets. (Note that when I say six months' to two years' worth of living expenses, I'm talking about living expenses not supplied by Social Security or a pension. If those stable income sources are supplying most of your living expenses, your cash stake would be quite small.) That cash cushion is the linchpin of the bucket strategy for retirement portfolio planning.

Bargain-hunters at all life stages might also want to use a declining market as an impetus to check up on their portfolios' liquid reserves, so that they'll have ready assets to deploy once they've done their homework. Alternatively, delegators who aren't comfortable sifting for bargains on their own may want to step up their contributions to the value-oriented mutual funds in their portfolios.

Revisit Your Ballast In addition to assessing your cash holdings, turbulent markets provide a good opportunity to assess your portfolio's ballast. Do you have holdings with the potential to gain--or at least not lose very much--during down markets? Gold has soared on Brexit news, but it's extraordinarily volatile and it's impossible to gauge its intrinsic value. I prefer more vanilla diversifiers; holding a reasonable allocation in a simple, high-quality bond fund will go a long way toward anchoring a portfolio with sizable equity exposure. This article explores which asset classes have been the most effective diversifiers for equity portfolios.

Stay Alert for Tax-Saving Opportunities Of course, there's no telling whether the market panic over Brexit will prove fleeting or more lasting. If the latter, it's important to remember that a silver lining of market sell-offs is the ability to improve your tax position. Investors in taxable accounts, for example, should be on the lookout for positions that have dropped below their purchase prices; selling such holdings will net tax losses that can be used to offset capital gains elsewhere in the portfolio or, if those gains exceed losses, up to $3,000 in ordinary income. Be aware that you can't rebuy the same security within 30 days of selling it without triggering the wash-sale rule, which disallows you from taking the tax loss. But you can buy a like-minded security—for example, you could sell one bank stock and buy another, or you could sell a bank stock and buy an exchange-traded fund that focuses on banks.

In a similar vein, converting Traditional IRA assets to Roth will incur less of a tax burden if executed after markets have fallen, because the taxes due on the conversion depend on the account's value. A tax advisor can help you determine whether it's a prudent time to convert some of your IRA assets to Roth.