What is a Financial Crisis? Is it worth investing during a recession? What about cash? Some key aspects of investing during a recession.
So, what is a Financial Crisis?
Let’s start with some basics, namely a brief definition of a financial crisis. Broadly speaking, a financial crisis is a situation where the value of assets declines rapidly or financial institutions face liquidity problems. Both cases usually lead to panic selling in the financial markets.
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While financial crises might be limited to a single region, country or asset class (e.g, the Portuguese housing market), they are more likely to spread globally these days. Financial markets have become highly interconnected amid financial liberalisation that began several decades ago. The immediate roots of such crises could vary — it could be a bursting of speculative bubbles, a war leading to a market crash, or ultimately a global pandemic. One thing is for sure — investors should be prepared for such circumstances as any crisis will likely affect their portfolio but also create market opportunities.
What Causes a Financial Crisis?
A financial crisis may have multiple causes. Generally, a crisis can occur if institutions or assets are overvalued and can be exacerbated by irrational or herd-like investor behaviour. For example, a rapid string of selloffs can result in lower asset prices, prompting individuals to dump assets or make huge savings withdrawals when a bank failure is rumoured.
Contributing factors to a financial crisis include systemic failures, unanticipated or uncontrollable human behaviour, incentives to take too much risk, regulatory absence or failures, or contagions that amount to a virus-like spread of problems from one institution or country to the next. If left unchecked, a crisis can cause an economy to go into a recession or depression. Even when measures are taken to avert a financial crisis, they can still happen, accelerate, or deepen.
Financial crises are not uncommon; they have happened for as long as the world has had currency. Some well-known financial crisis include: The 2007–2008 Global Financial Crisis. This financial crisis was the worst economic disaster since the Stock Market Crash of 1929. It started with a subprime mortgage lending crisis in 2007 and expanded into a global banking crisis with the failure of investment bank Lehman Brothers in September 2008. Huge bailouts and other measures meant to limit the spread of the damage failed, and the global economy fell into recession.
What Was the Cause of the 2008 Financial Crisis?
Although the crisis was attributed to many breakdowns, it was largely due to the bountiful issuance of sub-prime mortgages, which were frequently sold to investors on the secondary market. Bad debt increased as sub-prime mortgagors defaulted on their loans, leaving secondary market investors scrambling. Investment firms, insurance companies, and financial institutions slaughtered by their involvement with these mortgages required government bailouts as they neared insolvency. The bailouts adversely affected the market, sending stocks plummeting. Other markets responded in tow, creating global panic and an unstable market.
Is it worth investing during a recession? What about cash?
It is worth highlight that we should not invest the money needed for essential day-to-day expenses. Instead, we should invest funds that are not vital in the near future. As a general rule, people should always have a financial “reserve” available — ideally in cash. We can’t really predict the future, and as we realised in 2020, certain crises could be particularly intense for many industries.
However, every recession or crisis could also involve some great investment opportunities. A rapid sell-off in global financial markets will inevitably make various asset classes extremely cheap. Even though no one can be 100% sure that a particular asset will recover, it is very likely that some of them will recover sooner or later. Therefore, investors should always be prepared because once a financial crisis occurs, things can happen very quickly — a panic sale usually makes prices look like a waterfall.
Key aspects of investing during a recession
A financial crisis is usually associated with a recession, which marks a period of declining economic performance throughout the economy. Investing in such circumstances involves immense risk as market volatility is high and the future remains highly uncertain. There are several aspects of recession investing that should be considered.
“Don’t put all your eggs in one basket,” says an old saying. A diversified portfolio will reduce specific risk, thereby minimising total risk. It doesn’t just mean investing in numerous instruments but also buying different asset classes. Depending on the investor’s risk appetite, part of the portfolio may consist of relatively low-risk investments (solid dividend stocks, government bonds, precious metals, and cash), while the rest of the money could be allocated to riskier assets (growth stocks, cryptocurrencies, and CFDs).
Timing could be critical when things happen fast and markets crash. When markets remain extremely volatile, your portfolio may decline, and you may lose money. However, when volatility disappears, the likelihood of making better investment decisions increases. Obviously, no one is able to predict perfect entry points with absolute certainty.
Invest in time
For the reasons mentioned above, single-step investing (also known as lump-sum investing) seems risky amid market turbulence. Therefore, time investing or dollar-cost averaging may be a better decision for risk-averse investors, as spreading an investment into smaller segments should reduce the risk associated with volatility.
Nerves of steel
Every investor has a different risk appetite. Investing during a recession will certainly be extremely distressing for some investors — just imagine your portfolio losing 10% of its value in a single day. Some market participants are not able to cope with such an environment, even though the markets may bounce back sometime in the near future. Therefore, you should be aware that investing during a crisis always requires nerves of steel.
Recessions are always tough times for investors, as everyone worries about the safety of their portfolios. However, no matter how devastating the crisis, people eventually begin to wonder how to make money during a falling stock market, which by definition should raise asset prices afterward. No one is able to predict the best entry or exit points, but using common sense and implementing some risk management strategies for your portfolio could give you a decent return — if not in the short term, probably in the long term.
Thank you for reading and don’t forget: Until next time, take care of your money!
In case you would like to listen to this information with some visual effects, you can watch our YouTube video here.
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