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Somehow, finance executives around the world apparently forgot how to manage risk in a rising interest rate environment. A banking crisis ensued.
We, the humble depositors in those banks or others, shall be wiser. We will not put our hard-earned cash, investments or retirement nest eggs in danger of massive loss or default.
Let’s remind ourselves of some important money-managing lessons that the banking execs should have remembered.
This is (sort of) what the Fed wanted to happen
The Federal Reserve’s plan to slow an inflationary economy is — suddenly — working. That’s how monetary policy often works. To lower consumer prices, bad (economic) things have to happen.
Two or three bank failures and growing concern for the global financial system aside, the Fed was trying to break a few things; among them, the continuing cycle of economic growth and the momentum of full employment. Sorry, not sorry, Fed Chair Jerome Powell might say.
The rise in interest rates has been widely reported. We’ve all heard about it, right? The bigwigs at a few banks must have been out of town.
“Each of the failed banks focused on a risky, concentrated customer segment, quickly grew deposits, converted these funds into loans and bonds when interest rates were low, and assumed interest rates would not quickly rise,” Mark Williams, a master lecturer in finance at Boston University’s Questrom School of Business and a former bank examiner for the Federal Reserve, said in an analysis.
So, a quick recap:
- Ignored risky concentration.
- Bought fixed-income investments when interest rates were low.
- Made a flawed assumption.
Here’s how you can avoid the same mistakes.
Avoid risky concentrations
Banks that serve specific types of customers, such as startup companies or cryptocurrency platforms and users, are subject to the risks associated with those ventures.
Investors are often warned to avoid concentrated holdings, such as a single stock, a large share of crypto or even too much cash. Advisers always recommend investment diversification. It’s a many-layered blanket protecting you from risk. It begins with the major investment groups: stocks, bonds and cash.
From there, the risk factor is further filtered with subclassifications, such as:
- Types of stocks. These can be sorted by size of the company, industry, geography and whether it is a growth or value play. Equity investments can also broadly include alternative assets, such as real estate, commodities and, of course, cryptocurrencies.
- Fixed-income investments. For example, corporate, municipal and government bonds. From there, credit quality and time to maturity allow a further mix of risk.
- Liquid investments. Even the cash component of a portfolio can be diversified with money market funds, certificates of deposit and money held in checking and savings accounts.
Risk — and investment costs — can also be dialed down by buying index funds or exchange-traded funds rather than individual holdings.
Also see: How do higher mortgage rates help shrink inflation? Here’s an explainer.
Fixed-income investments and rising interest rates
The troubled banks bought income-producing investments when interest rates were low, analysts say. But when rates are at historic lows, it’s a pretty good bet that sooner or later, they will rise.
And rise they did.
When interest rates go up, generally, bond values go down. That’s not a problem if you’re a “buy-and-hold investor.” The bonds will redeem at their face value when they mature.
The problem is if you buy the bonds and have to sell them — due to an unexpected crisis — as interest rates are quickly rising. You’re likely to lose money. And the banks lost money in front-loader bucketfuls.
That’s why an emergency fund is so important. It’s a cash cushion you can tap into when unexpected things occur, so you don’t have to liquidate long-term investments at a potential loss.
Don’t miss: Food insecurity in America reaches the highest level in four years
Hope is not a strategy
Last, the banks are said to have assumed that interest rates wouldn’t rise as quickly as they did. That’s the most troubling risk of all: counting on an outcome that favors a result you prefer.
Our brains will often distort reality just enough to conform to our experiences, help us feel better about our choices and ease the pain of uncertainty. We lean on a bias of optimism to believe that future outcomes will be in our favor.
Interest rates won’t rise too fast — we’ll be fine, the banks thought. I’ll retire on the massive gains we’ll see in crypto, some investors hope. Tulips are the best investment, said the purported 17th century speculator.
Then there’s FOMO, and the herd
Because word got out that they were in trouble, the failed banks were ultimately short on cash to pay nervous depositors. One bank started bleeding assets after a noted Silicon Valley venture capitalist advised his portfolio companies to withdraw their money. Word got out, and soon an old-fashioned bank run was underway.
Bank runs “are a classic example of herd behavior, where individuals follow the actions of others, even if those actions may not be in their best interest,” Jadrian Wooten, an economics educator and researcher at Virginia Tech University, wrote in a recent Monday Morning Economist newsletter.
Plus: Mortgage rates dip amid economic uncertainty
In a social-media-first society, the roar of the crowd is hard to ignore. But sometimes it’s best to ignore the noise and stick with a long-term financial plan.
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Hal M. Bundrick, CFP® writes for NerdWallet. Email: hal@nerdwallet.com. Twitter: @halmbundrick.
