Investing is a way to grow wealth over time, beat inflation, and achieve financial goals such as saving for retirement, generating passive income or funding their children’s education. However, it can be a daunting task, especially for those who are new to the market or for those who are investing in a new asset class like cryptocurrency, even more so when investing comes with risks.
In early March 2023, the finance industry was shaken when three major banks, Silvergate, Signature Bank and Silicon Valley Bank (SVB) announced that they will be shutting down due to the liquidity crisis. Billions of deposits were withdrawn causing bank runs across the three key players, and chaos in the broader market.
Later in the same month, Credit Suisse, the second-largest bank in Switzerland faced a collapse and was acquired by its rival UBS for 3 billion Swiss francs. This event occurred after Credit Suisse had been involved in several scandals, including a spying scandal, the failure of two investment funds, and a revolving door of executives.
Failure of these recent financial institutions, which are integral to the industry, had a ripple effect on the global financial system. This also greatly highlighted the importance of understanding how such risk dynamics can impact investors and their portfolio exposure, serving as a reminder of the significance of diversification in investment strategy.
History of Bank Runs
A bank run occurs when a large number of customers withdraw their deposits from a bank, typically due to concerns about the bank’s solvency or stability. The fear of the bank’s failure can quickly spread among customers, leading to a rush of withdrawals that can ultimately cause the bank to run out of cash and be insolvent.
More than a decade prior to the unfortunate collapse of Silvergate, Signature Bank and SVB, Bear Stearns, a bank that relied heavily on short-maturity bonds to finance long-term investments, faced a bank run in 2008. Its industry rivals launched a public campaign against Bear Stearns, claiming it was unable to meet its obligations. This resulted in the bank’s capital base plummeting from US$17 billion to US$2 billion, leading to its bankruptcy filing. This event triggered the failure of 25 other banks including Washington Mutual and IndyMac.
Another high-profile bank run happened in the 1930s, also known as the Great Depression, when the banking system faced bank runs due to their high level of leverage and riskier loans. The crash of the stock market in 1929 led to banks being unable to meet their customer’s demands, causing widespread bank failures and a massive exodus of deposits from the banking system.
The recent collapse of SVB was a swift and unprecedented event, compared to the months-long Washington Mutual failure of 2008. Social media and online banking accessibility are considered contributing factors to the current crisis, as anxious depositors quickly spread their fears through various platforms. Experts point out that the rapid dissemination of info in the age of social media amplifies the psychological behaviour behind the twitter-fuelled bank run, potentially leading to a viral panic that regulators may struggle to contain. Michael Imerman, a professor at Paul Merage School of Business at the University of California-Irvine, has dubbed the SVB situation a “bank sprint” rather than a “bank run”, with social media playing a central role in its acceleration.
Is TradFi in Trouble?
Recently, additional tier 1 (AT1) bonds have been in the spotlight due to the situation at Credit Suisse. The bank announced that, following orders from the Swiss Financial Market Supervisory Authority, the value of 16 billion Swiss francs (USD$17 billion) in AT1s would be reduced to zero. This decision is controversial, as normally shareholders should be the first ones to bear losses, followed by holders of AT1 bonds. However, in this case, Credit Suisse shareholders will receive compensation in the form of UBS stock, while AT1 bondholders will receive nothing. This situation has created uncertainty for investors holding other banks’ AT1s, and some have raised concerns about the decision.
AT1 was introduced to increase banks’ safety buffers and reduce the risk of government bailouts following the 2008 financial crisis. These bonds are designed to convert into equity in case the lender encounters financial difficulties. The development of Bitcoin by Satoshi Nakamoto was likely influenced by the crisis, which acted as a motivation for the project. It is possible that Nakamoto had been working on Bitcoin before the crisis, but the events certainly played a significant role in his decision to create it. In one of his 2009 posts, Nakamoto noted that traditional currency requires a great deal of trust, which is often breached in the history of fiat currencies. He highlighted the need for a decentralized currency that could eliminate the need for trust in a central authority, such as the central bank.
Given as we have seen in just the past few months where countries have stepped up on the global stage and declared their intentions to lower their dependence on the dollar. This de-dollarization would thus be a matter of when, not if, as more and more countries realize the importance of diversifying their trust into other countries instead of placing it mainly with the U.S.
Does Diversification Matter?
Speaking of diversification, one does also have to apply the same logic to their investment portfolio. The goal of diversification is to minimize risk and maximize returns by reducing exposure to any single investment or asset class.
By diversifying a portfolio, an investor can mitigate potential losses resulting from fluctuations in the market or economic conditions that may negatively impact a particular asset or industry. One obvious trade which everyone is hopping on the bandwagon is investments into treasuries. We see large inflows of investments into money market funds in an effort to lock in high yields that have not been seen in the past 2 decades. There is no wrong in this strategy however, one must be aware in which the dependence of this trade is contingent on the U.S. government not defaulting on its ever increasing debt and being able to keep the dollar stable. This would obviously be a black swan event, however how do we hedge against such immense risk? We would need something hard, something of definite limited supply and typically gold and Bitcoin comes into mind.
According to a Yale study, Yale economist Aleh Tsyvinski says Bitcoin should occupy about 6% of every portfolio in order to achieve optimal construction. Even those who are strong Bitcoin skeptics should maintain at least 4% Bitcoin allocation. According to the study, Tsyvinski demonstrated that cryptocurrencies enjoy higher potential return than other asset types despite their higher volatility.
When measuring volatility, high readings indicate greater price fluctuations with both larger gains and losses, whereas lower readings indicate more stable returns. Usually, stable returns entail less potential significant profits as investors tend to compromise high returns for stability. Cryptocurrencies have demonstrated weekly returns that are higher than stocks since 2013 and as seen in the graph below.
Chart credit: https://www.moneygeek.com/investing/crypto/cryptocurrency-or-stocks/
To Diversify or not to Diversify?
The suitability of diversifying in an aggressive or passive allocation is dependent on one’s risk tolerance.
Diversification is a key investment strategy that involves spreading investments across various asset classes, industries, and geographical regions.
By diversifying, professional investors can reduce their exposure to any single investment or asset class, minimizing risk and maximizing returns. Fintonia Group, as a licensed fund manager, has a team of experienced professionals who can provide guidance and support to investors looking to diversify their portfolios. Whether you're new to investing or an experienced investor, we're here to help you build a customized solution that aligns with your risk tolerance, financial goals, and investment timeline.