“Eek! What’s up with the Greeks?”
By: Sam Swift, CFA, CFP®
If a friend had used the word “Grexit” in conversation five years ago I would have assumed he was speaking gibberish and questioned how much he had drank, but here we are. Grexit—the pundit’s preferred term for Greece exiting the Euro—is all over the news following the inability of both sides to reach a deal last week. The summary of how Greece got to where it is today is outside the scope of this post, but if you’re interested in a quick summary this video does a good job of laying it out.
What I want to talk about is how this crisis affects markets and what you should be doing about it.
How the Greek Crisis Affects Markets
Remember the fundamental rule of efficient markets: current market prices reflect all available information and investor expectations. Thus, for prices to change one of two things must happen:
- New information enters the market
- Investor expectations change
I’m going to go back to an old analogy to help explain this concept.
Let’s imagine I’m having a garage sale. I’ve put a $5 price tag on what I think is just some old painting, but is actually a Picasso. You happen to be an art dealer who has just stumbled upon my garage sale. In this simple case, you see a sweet deal and should be able to profit nicely off of this “mispriced” painting. But what happens if one other art dealer walks into my garage at the same time? What happens to the price of that painting as you two bid against each other? What if another art dealer then walks in? And then another? The price of that Picasso probably gets pretty close to what it’s actually worth. This is what happens in the financial markets, but with millions of participants. The combined knowledge and expectations of all participants is filtered into the price of each stock, or painting in our example.
Now, in the same garage sale scenario let’s assume that I have a television on. Breaking news comes through while we’re all standing there that there’s new evidence Picasso was actually a serial killer during his life. What’s going to happen to the price of the painting? To be honest, I’m not sure if that causes the price to go up or down (I don’t know the art market well), but it certainly is going to change one way or another. New information and the reaction of the art dealers are incorporated quickly and change the price. Again, this is the exact same mechanism that takes place in financial markets every day. In fact, the scope of financial markets are so large that new information and changing investor expectations are shifting prices every second—heck, every nano-second!
The Greek crisis is no different than any other piece of news in this regard. Market participants “place their bets” on what they think is most likely to happen. As new information becomes available or their expectations about the situation change, prices adjust. Remember that the current price of any stock always represents the point at which someone was willing to sell and someone was willing to buy—there are two sides to every transaction.
Despite the flood of new information with regards to Greece, markets haven’t yet reacted extremely one way or another. My take is that it seems both options—accept harsh austerity measures attached to another bailout or leave the Euro all together—are equally awful. Thus, from the market’s point of view, a terrible outcome is priced in for now one way or the other. Of course, that could change quickly if the situation turns out to be better or worse for the rest of the European Union members than previously thought. Time will tell.
What You Should be Doing About it
Nothing. That’s the short answer.
The Greek crisis and its ramifications happen to be the crisis du jour, but it will be something else soon. You may have already seen alarming headlines about the drop in China’s stock market, for example. (By the way, Greek stocks make up about 0.03% of a TCI equity portfolio and Chinese stocks make up about 1.3%–pretty close to each of their relative sizes in world market cap).
The point is that there will constantly be sources of uncertainty and risk. We need to embrace that. Without uncertainty or risk, we wouldn’t expect any meaningful long-term returns! Your cash in the bank is risk-free. It will not drop in value and it’s insured by the FDIC. How much interest are you earning on that right now?
If you’ve done the proper planning, your investments should be in an allocation that is suited to best meet your goals and aspirations. The inevitability of short-term drops in valuation is accounted for in any good plan. Here’s a chart of how the market has reacted in the past to other crises (and I don’t mean to imply that the current Greek crisis is necessarily as significant as the events listed here).
It’s often painful and scary in the short-term, but the longer-term power of the markets persists. Your plan should account for this and be able to ride out short-term drops in value. Trust in the planning process allows you to control your reactions to current events and let the plan work.