Finance executives all over the globe seem to have forgotten how to manage risk in an environment of rising interest rates. A banking crisis ensued.
The humble depositors at these banks and others will be wiser. We won’t put our hard-earned money, investments, or retirement nest eggs at risk of loss or default.
Let us recall some money-management lessons that banking executives should have learned.
This is (sorta) what the Fed wanted
The Federal Reserve’s plan for slowing inflation is suddenly working. This is how monetary policy works often. Bad (economic) events are necessary to lower consumer prices.
The Fed tried to stop a few things, including the continued cycle of economic growth, and the momentum towards full employment. Jerome Powell, Fed Chair, might have said sorry but not sorry.
It has been widely reported that interest rates have risen. It’s something we have all heard of. It was a strange sight to see the bigwigs of a few banks out of town.
“Each of these failed banks concentrated on a risky and concentrated customer segment. They quickly grew deposits and converted these funds into loans or bonds when interest rates rose. This was according to Mark Williams, a Boston University master lecturer in finance and former Federal Reserve bank examiner.
So, a quick recap:
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Avoided risky concentration.
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Fixed-income investments purchased when interest rates were low.
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A flawed assumption.
How to avoid making the same mistakes.
Avoid dangerous concentrations
Banks that cater to specific customers such as startups or users of cryptocurrency platforms and platforms are subject to the risk associated with these ventures.
Concentrated holdings such as one stock or a large amount of crypto, or cash, are discouraged by advisors. Investment diversification is a recommendation of advisors. This is a multi-layered protection that protects you against risk. It starts with the most important investment groups: stocks and bonds, as well as cash.
The risk factor can then be further filtered using subclassifications such as
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There are many types of stocks. You can sort them by company size, industry, geography, and whether they are a growth or value investment. Alternative assets such as commodities, real estate and cryptocurrencies can be included in equity investments.
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Fixed-income investments. These include municipal, corporate and government bonds. Credit quality and time to maturity can be added to allow for additional risk.
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Liquid investments.
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Fixed-income investments with rising interest rates
Analysts say that troubled banks purchased income-producing investments at low interest rates. It’s possible to bet that rates will rise sooner or later when they are at their lowest point in history.
They rose.
Bond values tend to fall when interest rates rise. If you are a “buy and hold investor”, this is not an issue. When the bonds mature, they will be redeemed at their face value.
Problem is, if you purchase bonds and then have to sell them due to an unanticipated crisis, interest rates will quickly rise. It’s likely that you will lose money. The banks also lost money in large front-loader batches.
An emergency fund is essential. You can have a cash cushion that you can draw on in the event of an unexpected event, and you won’t need to liquidate your long-term investments for a loss.
Hope isn’t a strategy
The banks believed that they assumed that interest rates would not rise as fast as they did. This is the biggest risk: relying on an outcome you favor.
Our brains can often distort reality to make us feel better and less anxious. To believe that the future will favor us, we rely on optimism.
The banks believed that interest rates would not rise too quickly — we will be fine. Some investors believe that I will retire on the huge gains in crypto. According to a purported 17th-century speculator, tulips are the best investment.
There’s FOMO and the herd
The banks that failed were eventually short of cash to pay anxious depositors after word spread about their financial woes. After a prominent Silicon Valley venture capitalist advised portfolio companies to withdraw their funds, one bank began bleeding assets. Soon, word spread and a bank run became a reality.
Bank runs are a classic example in herd behavior where individuals follow others’ actions even though they may not be in their best interests,” Jadrian Wooten (an economics educator and researcher at Virginia Tech University) wrote in a Monday Morning Economist newsletter.
It’s hard to ignore the roaring crowd in a social media-first society. Sometimes it is best to ignore the crowd and stick to a long-term financial strategy.