Investment Strategy Lessons Courtesy of Cyprus
The current crisis in Cyprus is a sad example of the mistakes that many professional and retail investors make when creating an investment strategy. This bailout plan is painful, but it is only a symptom of the problem, not the cause.
While much blame will be placed on finance ministers and international organizations, such as the International Monetary Fund (IMF), I believe the real blame, which stems from one of the most common and biggest investor mistakes, lies in the mismanagement of capital by the banks themselves—the mistake: not diversifying their assets.
Essentially, the current crisis stems from the fact that Cypriot banks are approximately 7.5-times larger than the entire country. These funds come in the form of deposits into the banks, which then need to create an investment strategy for this capital.
In most normal economies, the banks take in deposits and lend to businesses, supply mortgages for homeowners, and make various investments, both domestically and internationally. The biggest investor mistakes occur when there is a lack of diversification.
Because Cyprus is so tiny, these banks cannot properly diversify their investment strategy domestically. Instead of spreading the capital amongst various international investments, they essentially pumped a huge share of this capital into Greek bonds.
While hindsight is 20/20, and we now know how bad an investment strategy this was, even before the crisis, a proper risk evaluation should have told anyone that this is one of the biggest investor mistakes possible.
When the Greek bonds tanked and investors in these bonds had to take a haircut, the assets on the books of Cypriot banks declined substantially versus their liabilities, which are the deposits that they are supposed to hold and eventually give back.
The investment strategy to create a positive return for Cypriot banks backfired due to one of the oldest and biggest investor mistakes—putting a lot of eggs in one basket.
Had Cypriot banks created a diversified investment strategy that incorporated only a tiny portion in Greek bonds, but also held American bonds, Canadian bonds, and investment grade bonds in corporations, they would have completely avoided this crisis.
Many retail investors also incur problems because of the investment strategy of not diversifying. Everyone wants to find the “hot stock” that will send their portfolio soaring. That is a recipe for disaster.
Not every person will have the same investment strategy regarding diversification. However, there are many books that can help educate someone in avoiding the biggest investor mistakes possible. Generally speaking, I would avoid allotting more than five percent of my portfolio to anyone stock; preferably, I’d stick closer to two to three percent.
Additionally, the investment strategy must also limit exposure to any one sector. Perhaps I like banks and gold miners. However, I would only want to have exposure limited in each sector to perhaps 15%, but that is my own risk preference.
Avoiding the biggest investor mistakes is not easy, which is why most people are unsuccessful investors over the long term. Everybody wants the easy way out. They want one winning stock to pile all their money into. Big mistake.
Creating an investment strategy for long-term financial success does take work, as does anything in life. If anyone has started their own business, they would know it’s not as easy as working 20 hours per week when they felt like it.
Among the biggest investor mistakes is a false sense of confidence, which is what Cyprus had when it invested so much money in Greek bonds. As an investment strategy, one needs to take into account the worst possible outcome and prepare for it.
Ultimately, the Cyprus situation will be resolved one way or another, and in a couple of months, no one will be talking about this crisis. However, what we should remember is not the crisis, but what led up to the crisis, which was a poor investment strategy conducted by the Cypriot bank managers who should be held accountable for the lack of diversification of each bank’s assets.