In our 2022 year-end commentary, we referenced Daniel Kahneman and told you, “The correct lesson to learn from surprises is that the world is surprising.” It seems appropriate that the first quarter of 2023 was defined by another big surprise - the collapse of two major banks, Silicon Valley Bank (SVB) and Signature Bank. What might be even more surprising is that despite these collapses and amidst the fear of a broader banking crisis, market returns were generally very positive in the first quarter.
Developed market international stocks led the way with a 9% return, while large-cap US stocks weren’t far behind, gaining 7.5% on the quarter. Emerging market stocks and small-cap US stocks also posted positive returns of 4% and 3%, respectively, while REITs were up about 2%. The broad bond market indices were up around 3% on the quarter as the Fed’s rate hikes slowed down. Inflation measures started trending down, leading to a decline in the commodity indices of about 8% in the quarter.
Two straight quarters of strong returns haven’t been enough to restore investor confidence, as the collapse of SVB and Signature triggered fears that we might be in for a repeat of the Great Financial Crisis of 2007-2009. In the years since then, we have seen relative stability in the banking industry, as illustrated in this graphic showing bank failures from 2001-2023.
So far, that crisis hasn’t materialized, though it’s too soon to say we are completely out of the woods. Fortunately, there are very few similarities between what happened this year and what happened in 2007-2009. The last crisis was triggered by risky subprime mortgage loans that became worthless when the housing bubble collapsed. SVB was primarily invested in US government bonds, generally considered the safest asset in the world. So why did it collapse?
The simple explanation is that they did not properly match their assets and liabilities, as they took too much duration risk by holding longer-term bonds and did not have the liquidity to meet the cash needs of depositors. When interest rates rose quicker than expected last year, those long-term bond prices fell rapidly, and SVB had significant unrealized losses on those bonds. When depositors realized the extent of these losses, they started to withdraw cash, and SVB had to liquidate their bonds, making those losses “real”. This started an old-fashioned bank run with a modern twist. SVB’s customers are primarily in the venture capital world and very tech-savvy, so it didn’t take long for word of their troubles to spread through social media and the withdrawal requests to quickly exceed their ability to pay them.
While a mismatch of assets and liabilities was the trigger for their downfall, the real reason SVB collapsed was a loss of confidence. The bank didn’t invest in risky assets that became worthless; they invested in very safe assets that lost value on paper. If their depositors had kept their cash in the bank, eventually, those long-term bonds would have matured and the paper losses would have disappeared. Unfortunately, once some depositors lose confidence in a bank and start withdrawing money, things can quickly snowball as everyone loses confidence at the same time and tries to get their money out.
There are three big lessons we can learn from the downfall of SVB that you can apply to your own financial situation.
Match Assets with Liabilities
There are many ways to think about matching your assets with your liabilities, but we always start with your cash reserve. If you are retired, you should have cash/short-term assets covering 2-3 years of cash flow liabilities. If you are still working, you might only need 6 months of cash flow needs in reserve. Your stock portfolio should be considered a long-term asset that can be left invested to grow to meet future liabilities.
Don’t Reach for Yield
The reason SVB had so much invested in longer-term bonds is that short-term bonds were paying extremely low yields. Longer-duration bonds and high-dividend stocks might pay more income, but that doesn’t come without risk. It’s better to own a more diversified portfolio and to take a total return approach to your portfolio that considers both capital appreciation and income so you aren’t overexposed to one sector of the market.
Remember that SVB likely would have been fine if their depositors had stayed confident and left their money in the bank. You have an advantage over banks in that you only need to control your own behavior, not the behavior of thousands of customers. That doesn’t mean it will be easy, and a year like 2022, when stocks and bonds were both down double digits, will shake anyone’s confidence. Just remember how important it is to stay invested, as this chart showing the price of missing the best days of a rally illustrates:
The easiest way to remain confident and not panic with your investment portfolio is to develop a financial plan that aligns with your long-term goals. This means understanding your expenses and developing an asset allocation plan that matches your assets with your liabilities. It also means understanding your risk tolerance and ensuring you aren’t taking more risk in the portfolio than you are comfortable with. As always, if you’d like to revisit your financial plan or make changes to that plan, please contact us, as we are here to help!
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.