Over the last week the federal government needed to take extraordinary actions to assume control of two banks to reduce consumer concerns and prevent contagion throughout the U.S. banking system. The collapse of Silicon Valley Bank (SVB) on Friday, March 10, 2023, is the second biggest bank failure in U.S. history. Although many factors contributed to SVB’s failure and the subsequent takeover of Signature Bank, there are four lessons investors can take away from these events.
Lesson #1 – It is important to maintain an emergency savings account, but don’t keep too much in a low interest-earning bank account.
One factor contributing to the 2023 bank failures was their focus on business accounts. Many businesses, especially startup companies, require a lot of cash to run the business day-to-day. This requires businesses to maintain bank accounts with balances exceeding the federal deposit insurance limit. When word of SVB’s financial difficulties started to spread, businesses became concerned about their uninsured bank deposits. Companies started to request substantial withdrawals from SVB. On March 9, 2023, depositors tried to withdraw $42 billion in a single day. This flood of withdrawal requests, equal to almost a quarter SVB’s deposits, weakened its finances and ultimately caused bank regulators to close the bank.
One fundamental money rule for investors is to build an emergency savings account, or what we like to call a peace of mind account. Having sufficient funds in a secure, liquid savings account (typically equal to 3 to 6 months’ worth of living expenses or an amount that allows you to sleep well at night) allows you to be more confident when an unexpected expense arises by having funds available to pay for it.
The question some people might ask is, “how much savings is too much in a bank account?” When looking at the cash portion of your investments there are two important items to pay attention to: 1) To prevent a bank failure from potentially losing some of your cash savings, make sure it is covered by deposit insurance, and 2) Be aware of the interest rate being earned on your cash savings to make sure it is a reasonable rate.
FDIC deposit insurance protects your money in the event of a bank failure. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. The amount of FDIC insurance coverage you may be entitled to may depend on the ownership registration of your account. For example, you could own individual accounts, certain retirement accounts, employee benefit plan accounts, joint accounts, trust accounts, or business accounts.
According to the FDIC, “Deposits held in different ownership categories are separately insured, up to at least $250,000, even if held at the same bank. For example, a revocable trust account (including living trusts and informal revocable trusts commonly referred to as payable on death (POD) accounts) with one owner naming three unique beneficiaries can be insured up to $750,000.”
You also should monitor the interest rate you are earning on your savings. Inflation will cause your saved dollars to be worth less over time. Therefore, you should strive to make sure your cash savings are earning a reasonable amount of interest. According to the FDIC, as of February 21, 2023, the national average annual percentage yield (APY) on savings accounts is only 0.35%. Yet many FDIC insured high yield savings accounts are paying interest rates of 3.50% or higher, more than 10 times the national average. We encourage you to make sure your cash savings are covered by deposit insurance and earning a reasonable amount of interest.
There are various investment options available to earn more interest than a bank savings account. Consider having a conversation with a financial coach to discuss what level of savings are appropriate for you and how you may be able to earn more interest on your savings.
Lesson #2 – Although investors may think all bonds are conservative investments, some can have a considerable amount of risk.
When you deposit money in a bank account, the bank does not put it in a vault waiting for your withdrawal request. To be profitable banks loan funds out to other customers or invest it to potentially generate more income than the interest it pays on deposits. During the pandemic SVB received a flood of deposits and invested a substantial portion of it in long-term government bonds and mortgage-backed securities to get a higher yield than short-term bonds. By investing in long-term bonds SVB exposed itself to “duration risk.”
The value of bonds is inversely related to interest rates: when interest rates go up, bond prices go down. For example, if you want to sell a bond paying 3% interest while a new similar bond is paying 4%, the value of the 3% bond will go down so the interest being earned is closer to the interest being paid by on a new bond. The amount the bond price fluctuates from a change in interest rates is related it’s duration, which is a measurement looking at a bond’s maturity, yield, coupon, and call features.
Over the last year the Federal Reserve increased short-term interest rates by almost 5.0%. This rapid rise in interest rates substantially reduced the value of long-term bonds. When SVB started receiving a large amount of withdrawal requests it needed to sell $21 billion of bond investments which resulted in an after-tax loss of approximately $1.8 billion. This investment loss, compounded by SVB’s financial problems, contributed to its failure.
As an investor it is important to determine the level of risk you want in your investment portfolio. Diversifying your portfolio with bonds can be one way to reduce risk. The second lesson to learn from the bank failures is the type of bonds you own in an investment portfolio is important. Certain types of bonds can add more risk, rather than reducing risk in your portfolio. You should know and understand the investments in your portfolio and the amount of risk you are exposed to. At Hammond Iles we believe a portfolio’s bond investments should focus on short-term, high credit quality bonds to provide stability and reduce duration risk.
If you are unaware of the types of bonds you own in your portfolio and would like to better understand the level of risk in your bond investments, contact our office for a complimentary conversation with a financial coach who can assist you in analyzing your portfolio.
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Lesson #3 – Investing in individual stocks can significantly increase the risk in your portfolio.
Investing in individual company stocks exposes your portfolio to a variety of risks. Sometimes investors think they can reduce risk in their portfolio by investing in companies that pay dividends, including banks and financial institutions. The recent bank failures highlight that there can be a significant amount of risk in dividend-paying stocks. First Republic Bank’s stock dropped 61.8% in a single day along with many other banks losing close to half their value.
Investors should understand that owning any individual stocks, whether the company pays dividends or not, has unsystematic risk. Unsystematic risk is the risk in a business or investment portfolio that is unique to being exposed to a specific company or industry. For example, by owning just one stock, you carry company risk that may not apply to other companies in the same sector of the market. What if the company's CEO and executive team leave unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? What if there is a run on the bank? These are just a few examples of the types of things that could happen to one company but are not likely to happen to all companies at once.
The good news is that diversification reduces unsystematic risk. By owning a diversified portfolio you can reduce your exposure to unsystematic risk. We believe you should understand the risk in your investment portfolio and what a possible worst-case scenario could be. Being exposed to unsystematic risk with individual companies could cause events like the recent bank failures to wipe out savings and investments that took a lifetime to accumulate.
Do you know how much risk is in your investment portfolio? If not, you should analyze your portfolio to fully understand the risk in your investment portfolio and what the possible outcomes could be over time. Knowing the level of risk in your portfolio can help you adjust the portfolio to potentially mitigate a future drop in value.
Lesson #4 – Diversification plays an important role in reducing risk to a business and in an investment portfolio.
A business runs a higher risk of failing with only one client. If it loses the client, the business loses its only revenue. The same type of risk exists if a business focuses on serving one industry or market sector. Both SVB and Signature bank focused on providing bank services to a specific industry or sector. SVB served startup companies, largely technology companies, and Signature Bank focused on crypto-currency companies. Focusing on these areas fueled each bank’s dramatic growth over the last few years, but it also exposed them to more unsystematic risk. Without a diversified customer base, the banks started to struggle as the startup and crypto-currency companies rapidly increased bank withdrawal requests.
As an investor it can be easy to focus on a specific investment or market sector that is doing well for a period of time. Your human instinct is to move toward pleasure, try to earn more, and capture a higher rate of return while an investment is “on a roll.” It can be emotionally difficult to avoid this desire. Yet, as we witnessed with the bank failures and financial market crashes in the past, too much of a good thing can lead to financial ruin. We believe a more sustainable path to more comfort and confidence for long-term portfolio performance includes a globally diversified portfolio, some level of stock and bond market exposure based on your risk preference, and systematic rebalancing of the portfolio to maintain your desired level of risk.
Despite the recent bank failures causing concern and putting stress on what we believe is a sound U.S. banking system, the demise of these two banks illustrated four lessons for investors. It is important to make sure your cash savings are insured and working for you. The bond exposure in your portfolio should focus on short-term, high credit quality bonds to provide stability and reduce risk in your portfolio. Focusing on “hot” sectors or industries can increase risk in your portfolio. Investors should use diversification to reduce risk and potentially increase returns over time.
Having a financial plan, a solid understanding of your investment portfolio and the processes used to manage it may allow you to worry less when the markets are volatile. We offer monthly online financial education workshops, an investing community, and a no-cost initial conversation with a financial coach for anyone who has questions on investing and money matters.
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All investing involves risk, and particular investment outcomes are not guaranteed. This material is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, or an offer to provide advisory or other services by Hammond Iles Wealth Advisors in any jurisdiction in which such an offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this article should not be construed as financial or investment advice on any subject matter.