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Diversification: how to prevent financial collapse

Updated: Apr 5

Over the weekend in the US, Silicon Valley Bank (SVB) went under. Banks fail all the time, but this was a rather large one with a correspondingly larger effect on the US economy. US based companies make up about half of the entire stock market, so this has effects around the world. The main reason this bank failed was that it wasn't diversified in its clientele and in its income streams.

Why did this bank fail? SVB specialized in working mostly with start-ups and technology firms. SVB became one of the 20 largest banks in the US because many of the start-ups that use their service became successful. During 2020 there was a pandemic tech boom that further increased the deposits at SVB.

Most banks make money by giving loans, but since SVB's clients were all doing so well, they weren't interested in loans. So SVB invested their deposits in long term government bonds instead. When many of their customers wanted to withdraw deposits during the recent tech slump, SVB had to sell off some of their bonds at a loss to free up the cash. And here we have insolvency. (An even better summary of the situation )

In the long run, it's likely that this event will only be a small blip in the history of the world economy, probably not worth thinking too much about for the average person. However, it's a perfect lesson in the value of diversification.

If SVB had a diversified client base such a large portion of their clients may not have needed to withdraw cash all at the same time. If their clients weren't mostly start-ups and tech some may have needed loans at the time when other clients had extra cash piling up (so they wouldn't have needed to invest in so many long term bonds). SVB's client base were all reacting to the same market factors in the same ways.

If SVB had diversified their investments (other than just long term bonds) then the rising interest rates wouldn't have sent all of their investments in to loss.

Diversification balances out the unpredictable future. If one asset goes down, it's likely that another will be going up. The more different types of assets you have, the less likely that all of them will be losing value at the same time.

How do you diversify your assets? The simplest way is to invest in a whole index tracking ETF.

Index funds are mutual funds or ETFs that you buy that contain many stocks inside of them. They're essentially a basket of stocks. There are many forms of index funds. Some contain only one sector of stocks--like the tech sector. This doesn't diversify your portfolio. You want to invest in a whole index tracking fund. This type of asset contains a large percentage of the stocks available on the market and seeks to replicate the performance of the whole stock market.

The first index fund was created in 1975 by James Bogle, the head of Vanguard. This is why this type of investing is often called "Bogleheads" style investing and why many people like to buy Vanguard index funds like VT (for Americans) or VWRD (for everyone else), but they're not the only option.

You can also buy index funds for bonds, IGLO is a popular choice for non-americans, BND for Americans. Of course there are many more options available.

The point is that you can diversify your investments while only actually buying one or two ETFs. It's simple, it saves you time and money, and it provides the security of diversification.

The headquarters of Silicon Valley Bank at 3003 West Tasman Drive, Santa Clara, California.

Image credit: Minh Nguyen 2023, licensed under the Creative CommonsAttribution-Share Alike 4.0 International license.

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