Polls / December 2, 2010

Do you know what financial contagion is and why it matters to investors?

Just 22% of respondents to an eZonomics online poll know what financial contagion is and why it is important to investors.

Financial contagion spreads from one country to another
Financial contagion is the transmission of economic and financial difficulties – usually from one country to another (although it can also happen between companies). It was topical at the time of writing because economic troubles in Ireland were causing some investors to question whether they wanted to continue investments in some other European countries.

These investors were likely to fear that financial woes in Ireland could be repeated elsewhere – even if the exact same factors causing the troubles are not necessarily being repated. In practical terms, it is said that such fears can cause drops in share markets in several countries and also lead to higher interest rates for certain government loans. Bad news spreads in different ways

Financial contagion is not new 
In their influential 2009 book This Time is Different, Carmen Reinhart and Kenneth Rogoff look back at the history of financial crises over 800 years and identify two types of financial contagion. They describe the two types as the “slow burn” spillover and the “fast and furious”. In the book, they say the “slow burn” typically follows an initially small reaction to an event made up of “gradual and protracted” responses that together have major economic consequences. The “fast and furious”, however, can happen in hours or days.

Diversification protects against contagion
At the national and international level, federal financial support may be put in place in an attempt to reassure investors and halt contagion. At the personal level, diversification can help protect investors against the worst effects of contagion. This diversification might be achieved by ensuring savings and investments are spread geographically and across different asset classes. The basic principles of diversification are explained in the eZonomics video The share market has risen. Is it too late to dive in?.

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