What is... | September 16, 2011

What is a safe haven?

For sailors and refugees a safe haven is a place of protection or sanctuary during troubled times. For investors, the concept is similar.

Investors may seek to move capital to the safest possible investment to protect it from loss during an unsettling period. But an important difference between a physical and a financial "safe haven" is that in volatile times, assets once seen as safe can swiftly turn out to be treacherous. Behavioural traits in financial markets can partly explain both the flight to safety and the sudden shift of assets from safe to risky.

Flight to safety
Analysts say investors are often driven by two “animal spirits” – greed and fear. The idea goes that when investors are confident about the outlook, they are happy to take risks in search of higher rewards (the “greed”). But when that confidence turns to fright, they flee to buy assets seen as safe (the “fear”). We saw the greed and fear play out when the global financial crisis hit in August 2007. Investors rushed to sell complex structured products and shares that had provided high returns in the preceding years.

Many then bought “safe” government bonds. The eZonomics story What is… financial risk? details assets that are typically considered “safe” (such as government bonds and cash deposits) and assets that come with higher risk. It warns, however, that there is no such thing as a risk-free investment, as demonstrated by past cases of governments collapsing and defaulting on bond repayments.

Storm in the port
A flight to safety can cause the price of safe haven assets to rise quickly, causing a problem. Herd mentality can work both when asset prices are rising and when they are falling. The price of gold, for example, rose to record highs after the latest global financial crisis as investors rushed in and pushed up the price.

Such a rapid rise in the price of “safe” assets can make those same assets turn and become unsafe. The price can rise so high that it overshoots fair value and becomes unsustainable. With gold, some have warned the price appears unsustainably high. Just as greed can drive prices of risky assets to unsustainable levels, so too fear can push the price of safe assets to levels that cannot be justified.

The case of the “franc zapper”
Another problem for safe havens can be regulatory risk. The rules governing the way markets operate can change, meaning a safe haven asset can become more risky or more difficult to access. An example is the Swiss franc, or CHF, considered a safe haven currency for most of 2011.

European investors battered by falls in prices of stocks and government bonds in less financially-stable countries bought the Swiss franc as a safe haven, pushing up the small country’s exchange rate and causing difficulties for its economy. The Swiss National Bank responded in September 2011 by announcing it would set a minimum exchange rate target for the euro and the Swiss franc, effectively weakening the CHF.

Investors incurred foreign currency losses and it prompted theUK's  Financial Times to dub the Swiss central bank a “franc zapper”, a playful pun on the name of musician Frank Zappa.

The safest play
The safest of all assets is cash held at the bank. Even then, losses can occur if very low interest rates produce returns lower than management fees. Inflation can also reduce the purchasing power of cash when interest rates are very low.

Remember that for investors, safe havens can be useful. But don’t forget the influence greed, fear and herd behaviour can have, turning a financial sanctuary into a place of financial turmoil.

SavingRiskCash Gold

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics