Updated: May 31
Explaining the Dynamics of a Financial Crisis, and your best Course of Action for Financial Security
"I have published this article on Sep 8, 2019 on my Medium account, anticipating a financial crisis in 2020. I decided to republish it now, as it is more relevant with the Corona Pandemic that might be the trigger to spark an unprecedented financial crisis. The article is republished as is without an edit. I'll be publishing a new article about the current financial crisis soon."
You might have already heard that a lot of economists are predicting a global financial crisis within a year or two, and this is scary enough. However, the pragmatic question that you should be asking yourself now is:
“How can I be financially secured, when a crisis hits?”
This article is not an investment guide, but rather a blueprint that helps you understand the dynamics of a financial crisis. The goal is to help you understand the environment you’ll be in during a financial crisis, allowing you to make wiser decisions on how to manage your financials in such times.
But First, What Is a Financial Crisis?
In terms of economics, a financial crisis is a period of the economic cycle where asset prices see a steep decline in value, businesses and consumers are unable to pay their debts, and financial institutions experience liquidity shortages. A crisis comes after a long period of economic growth, completing the natural debt cycle of a boom and a bust.Long Term and Short Term Debt Cycles
A financial crisis is often associated with a panic or a bank run during which investors sell off assets or withdraw money from savings accounts because they fear that the value of those assets will drop if they remain in a financial institution. Generally speaking, people tend to spend less, and save more as they lose trust in the economy. This period is accompanied by policy makers playing an active role trying to mitigate the crisis. Their goal in a nutshell would be to restore the trust in an economy that is falling, causing huge fluctuations in the markets in doing so, until the crisis is finally over, and economy is back on track. It is quite remarkable that we tend to be surprised whenever a financial crisis hit, even though it had happened systematically every 10 years on average, the last being the 2008 crisis. This lead statistician Nassim Nicholas Taleb to dub it a Black Swan Event which he identifies as: “a rare event that hits us as a surprise due to our blindness with respect to randomness, particularly large deviations.”Financial crises may differ in terms of severity and duration, but the general outlook is more or less the same. We can learn from previous financial crises to better prepare for the upcoming one, and current stats do show that we are on the verge of another financial crisis. You can read about some of its leading indicators here.
So how do you prepare for a financial crisis?
Studying past financial crises makes you realize that there is a pattern that you can derive from it the best course of action to take in order to be in a better position when a crisis hits. The analysis below should help you create your own investment strategy during such times.
In financial terms, you should own Liquid Assets: that are Cash, or assets that could be easily converted to cash. In practical terms, you should make sure that you can easily get your basic needs during a financial crisis, and owning cash is the easiest way to guarantee so.
a) Own your Local Currency
If you live in Europe, own Euros. If you live in the States, own USD. If you live in a Turkey, own its Lira. The logic is simple, own whatever currency that’s being used the most to purchase commodities in the country that you live in.
By cash, I mean cash in hand, not cash in your bank account, since banks might limit your ability to withdraw your own money in times of a crisis, like what happened in Greece since 2010, when government imposed a limit of 60 Euros on daily Bank Withdrawal.
You might be worried that your cash holdings would lose its value in times of a crisis, which is a very valid concern. However, if you don’t have enough cash to cover your basic needs, you shouldn’t really think of looking for investments or safe havens as it will make it harder to buy your basic needs. You might be forced to sell your financial assets at a lower price if truly in need.
B) Diversify your Cash holdings
Once you have enough local cash to cover your basic needs for a couple of months, you might consider holding foreign cash to diversify your risk.
A financial crisis comes with the risk of a currency crisis and a potential currency devaluation if needed. It takes further detailed analysis to predict which currency will be a better holding in times of a crisis, and this is done case by case, and requires deep financial and political understanding.
However, what you can easily do regardless of the specific case of any financial crisis, is to own multiple currencies to hedge your risk. Don’t put all your eggs in one basket in a nutshell.
Popular currencies to hold are the U.S. Dollar, Euro, Japanese Yen, and potentially Chinese Yuan.
2- Look for safe havens
When you make sure you have enough liquidity to manage your life during a financial crisis, you may consider investing in what is considered to be Safe Havens, which are investments that normally increase in value during times of market turbulence. They are sought by investors to limit their exposure to losses in the event of market downturns. Cash is definitely a popular safe haven, but there are others that could appreciate more in value in times of a crisis allowing you to make profit when most of the financial markets are going down.
Popular safe havens are:
For years, gold has been considered a store of value. As a physical commodity, it cannot be printed like money, and its value is not impacted by interest rate decisions made by a government. Because gold has historically maintained its value over time, investors tend to pile their funds into gold during a market downturn, driving its price up due to an increase in demand. It would be wise to ride this wave and buy gold in anticipation of a financial crisis hit.
An interesting case to study about Gold prices is the 2008 crisis. Gold prices fell in 2008 due to liquidity shortages where institutional and personal investors sold gold to get cash. The supply increased and hence the price dropped. However, as time went by and the liquidity issue was managed, the prices of gold soared as investors sought gold as a safe haven for their money effectively increasing the demand on gold and hence the prices went up.
As a precious metal like gold, silver is considered to be a storage of value, but there is a twist:
Unlike gold, 60% of silver is being used for industrial fabrications.
This means that there is a correlation between industrial growth, and silver price. However, during a financial crisis, the demand of silver as a storage of value increase at a higher rate than the drop in industrial demand, effectively increasing its value as a result.
Moreover, the current Silver to Gold price ratio has reached a historical high of 91:1, way above its all time historical natural ratio of 18 to 1, making Silver a lucrative asset to purchase.
C) Crypto Currencies
Cryptocurrencies is considered a fairly new financial asset that doesn’t have a historical record on how it works in times of a financial crisis. Nevertheless, it has exponentially increased in value in recent years.
One could see cryptocurrencies as the anti-government, anti-central banks currency, due to its decentralized nature. For that reason, cryptocurrencies value correlates negatively with people’s trust in the government to manage a financial crisis successfully. In other words, if the public doesn’t have faith in the government to solve the crisis, Crypto currencies will see an increase in value, and due to its relatively small market capitalization, the increase would be exponential.
“The Times 03/ Jan/2009 Chancellor on brink of second bailout for banks” -The first block of the bitcoin blockchain
It is noteworthy to mention that there are thousands of cryptocurrencies out there. Yet, the one to seek as a storage of value not for mere market speculation is the one and only Bitcoin.
D) Defensive Financial Assets
It is quite understandable that in times of a financial crisis, people tend to save more, and spend less. People will be less motivated to purchase a new house, car, or a TV. However, this doesn’t mean that people will stop spending money on necessities such as food and healthcare. As a matter of fact, people might panic and start hoarding necessity goods in such times, effectively increasing the demands on necessities.
Following that logic, financial assets that relates to basic needs would act as defensive stocks in your portfolio; meaning that they won’t lose much of their value when a crisis hit, and might even achieve some gains like the case of Walmart in the 2008 financial crisis.
There are quite a variety of financial assets that fits the above description from Discount Stores such as Walmart, to commodities like Corn, to healthcare related stocks, to farmland.
3- Become more Self-Sufficient
In pure economical terms, you will need to limit your exposure to the market during a financial crisis, and there isn’t a better way of doing so than being self-sufficient enough not to need the market.
It is important to realize that unemployment rates rise during a financial crisis, and lots of companies struggle to pay their employees on time, making it harder for the average person to make ends meet. It is very important to have some savings aside to survive such rough times. Unfortunately though, most people don’t have such luxury of savings. A recent study shows that almost 80% of US workers live from paycheck to paycheck.
Realizing the magnitude of the potential problem, the least you can do is to guarantee your food security, and one way of doing so is to start growing your own food.
The self-sustainable lifestyle is a broad topic that lots of environmentalists are suggesting to prevent Climate Change. However, its economical benefits for you as an individual is why it is mentioned here. You can effectively reduce your financial liabilities if you recycle, grow your own food and brew your own alcohol.
As a matter of fact, one of the assets that appreciate the most in times of a financial crisis is FarmLand. Getting your own farm might be the single most beneficial thing to do in times of a crisis. You can get the dual benefit of owning an asset that would appreciate in value, while securing your food stability for you and those around you at the same time.
It’s also nice to realize that you’ll be eating healthier food, as a byproduct of taking a decision that benefits you economically.
4- Make Fast Wins
If you think you are secured financially, and have extra money at your disposal, you may consider the option of trying to make some easy money during a financial crisis. There is no guarantees on returns but it is worth the speculation.
All you need to do is to understand that a financial crisis by definition is a time of a market downturn where asset prices see a steep decline in value. This will be accompanied by policy makers doing an active role trying to mitigate the crisis, causing fluctuations in the market. However, the general trend will be a downward trend especially in major stock prices.
Understanding this market dynamics during a financial crisis, you can consider doing the following:
A) Short Major Stocks Indices
By definition, stock prices will see a steep decline in value in times of a financial crisis, making it ideal to short major stock indices, that is betting that the stock market will go down. Even though getting the timing ultimately right is a bit tricky, it would be wise to short stocks in advance if you’re expecting a financial crisis. What might happen is that you’ll lose some value on the short term, but ultimately gain on the long run when a crisis finally hits.
A stock index is basically an indicator or measure of a hypothetical portfolio of securities representing a particular market or a segment of it. So, if you think the American economy will suffer in a crisis, you might consider shorting The Dow Jones Industrial Average, or the S&P 500. If signs show that the crisis will affect Europe the most, you might look at the French CAC 40, or the German DAX to short. If you’re not sure which country will suffer the most, apply the golden rule of diversification to reduce your risk and maximize your gains.
A long trade is initiated by purchasing with the expectation to sell at a higher price in the future and realize a profit. A short trade is initiated by selling, before buying, with the intent to repurchase the stock at a lower price and realize a profit.
B) Long VIX Index
The Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility, and it is derived from the S&P 500 index. It basically goes up, when there are huge fluctuations and instability in the market. Some people call it the “Fear Gauge” or “Fear Index” since it reflects investors’ fear in sustaining the current trend in the market.
Investing in VIX index as a bit more trickier than simply investing in stocks due to the complexity of the financial instruments that are derived from the VIX index. The volatility of the VIX index is also high, and hence huge gains or losses could be achieved within a single day. A notable example is when the VIX index doubled in value on a single day. It was 5th of February 2018 when the S&P500 had its biggest single day loss in history after a long positive run.
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At the end of the day, we should all realize that financial crises are inevitable. They happen organically in a systematic way due to the nature of Credit Economy. We cannot prevent them as long as we live in a capitalist economy. What we can do is to try to survive such times with the least amount of damage.
An important lesson that we could learn from history is that governments will interfere to protect big businesses and large financial institutions from failure, while neglecting individuals and small businesses. In other words, as individuals we should rely on ourselves not on our governments to sustain a financial crisis.
Regardless of your current financial situation, the things that you can start doing now are: improving your self-sufficiency level, having cash in hand, and supporting each others instead of waiting on your government for solutions.
Reflections from the Author
As Homo Sapiens, we’re meant to eat, sleep, reproduce and find a shelter and that’s the core of our “human nature” or “animal instinct”. Unlike Animals though, we have to get money first… We added this extra layer of complexity and now, we spend most of our days to get money in order to live!