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What can retired investors learn from bank collapses?

March 24, 2023

The collapse of Silicon Valley Bank and Signature Bank in the last few weeks—the second and third largest bank failures in history—have been dominating financial headlines. But as I’ve read their stories to understand what went wrong, I couldn’t help but notice how common their mistakes were and how many important lessons we can take from their demises. Especially for retired investors who have shifted from saving to withdrawing funds from their portfolios.

Be Careful With Bonds

The first and most straightforward mistake to highlight from these bank failures is the mismanagement of their investment portfolios. As I mentioned in an article last week, banks have basically two avenues to earn money on deposits—they can loan out those deposits and charge interest on the loans, or they can invest some of the deposits in a portfolio and pocket some of the earnings.

To overcome the challenge of record-low interest rates and low yields on the bonds that bank investment portfolios typically hold, it turns out that these failed banks extended the average maturity of their holdings to try and earn a higher yield. They held many bonds that didn’t mature for a decade or two. But higher yield comes with higher risk, and in the case of longer-term bonds, that risk shows up when interest rates rise, causing bond prices to fall. These banks suffered billions of dollars in losses last year as interest rates rose by more than 4%—much faster than almost anyone anticipated.

Didn’t they know it doesn’t pay to extend bond maturities? The graphic below reports the average return and volatility (standard deviation) for different government bond index maturities from one month out to 20 years, covering the period from 1963 (earliest data available for One-Year Treasury Notes) through 2022, which includes stretches of rising and falling interest rates. What do you notice? First, the safest, “risk-free” One-Month Treasury Bills barely exceeded the return on inflation. No risk, no reward. As you extend from 30 days out to a year, historical returns went up quite a bit without much increase in risk. Returns were still greater as you extended from one year to five years in maturity, but risk jumped as well. However, going out beyond five years in maturity saw little benefit—long-term (20-year) bonds had just 0.3% higher annual returns than five-year bonds but had double the volatility. Long-term bonds only outperformed one-year bonds by about 1% per year but had approximately 10x greater risk.

These banks didn’t seem to know investment history or believed they could time interest rates and sell their long-term bonds before rates increased. Retirees shouldn’t make the same mistakes.

A longer-term look at history, which all investors and especially retirees should familiarize themselves with, reveals that keeping bond portfolio maturities to five years or less has been the best way to earn modest real (net of inflation) returns with minimal risk.

Diversify, Diversify, Diversify

A large proportion of Silicon Valley Bank customers were in the technology industry—not just established technology companies but also start-ups and investment funds that targeted and catered to the tech industry. As I read about Signature Bank, I learned that they had a similar problem—a large percentage of their asset base was tied to the hyper-volatile cryptocurrency industry, which along with tech stocks and long-term bonds, saw record losses in 2022.

Both Silicon Valley and Signature Bank had one other depositor characteristic in common: they encouraged their clients to keep all their assets at their bank, even if the values eclipsed the $250,000 FDIC individual insurance limit. In return for taking the risk, both banks agreed to offer their customers better loan deals and various lifestyle perks, including exclusive invitations to social outings, tickets to sporting events, etc.

The banks’ deposit concentration in just a few high-risk industries, as well as the over-concentration of depositor accounts that exceeded the FDIC insurance levels, was a ticking time bomb primed for a large-scale succession of withdrawals.

This concentrated approach is the exact opposite of how I advise retirees to invest. Portfolios that Servo manages tend to have high levels of asset class diversification, not just between stocks and bonds, but are diversified globally within stocks and bonds. Our stock portfolios also own shares of large and small, growth and value stocks—not just common indexes like the S&P 500 that is concentrated in a small number of large growth and technology companies.

During periods such as the last ten years, or the decade of the 1990s, when US large cap growth stocks have been the top-performing asset class, diversified portfolios can seem unnecessary and out-of-step with the times. But what happens when US large cap stocks don’t do well? As we saw with Silicon Valley and Signature Banks, when you have concentrated exposure to only a few industries or investments, you can be punished when those segments experience hard times.

Regarding the S&P 500 Index, we saw a decade of hard times to start this century. The 2000-2009 period is known as “The Lost Decade” because large US stocks had negative returns for over ten years. But that didn’t mean that all stocks did poorly. Diversified investors who held shares of small stocks, lower-priced value stocks, and international stocks, did much better.

Retirees who had and kept all their stock allocation in the S&P 500 Index in 2000 after the roaring 1990s had an awful decade. If they continued withdrawals at a modest pace, they could have faced the serious risk of running out of money. But retirees who overcame the disappointment of lower (but still good) returns on diversified portfolios during the 1990 and maintained their allocations sailed through the 2000s decade with decent gains.

The chart below shows that the Dimensional Equity Balanced Strategy Index, comprised of all of the stock asset classes listed above, earned a rate of return of over +7% per year during this decade, and $1 invested in it more than doubled. The Dimensional 80/20 Balanced Strategy Index and Dimensional 60/40 Balanced Strategy Index, which have 80% and 60% allocated to the Equity Balanced Strategy Index and the remaining 20% and 40% in short-term bond indexes, also managed to produce healthy gains and did so with less short-term volatility, a combination that retirees often appreciate.

Don’t Lose Sight of the Big Picture

The legacies of Silicon Valley Bank and Signature Bank will ultimately be companies that eschewed the relatively stodgy and boring world of traditional banking in pursuit of rapid growth and outsized profits. They weren’t satisfied with growing at a measured pace or allocating their deposits to more conservative investments that may not be as immediately profitable but would be more sustainable and accessible should depositors need their money.

I sometimes see retirees making the same mistakes—focusing unnecessarily on short-term returns or chasing investments that have done well recently but do not have viable long-term prospects. This may work for a while, but the risks eventually appear.

When I talk to retired or soon-to-be-retired people for the first time, they often tell me that their goal is to “not lose money.” They don’t feel they can afford to see their portfolios decline and still live comfortably on their money. That’s understandable. But I explain that the biggest risk they face is not temporary losses; it’s the corrosive effects of long-term inflation on their principal and income. If retirees don’t invest so that their portfolio can earn a higher long-term return than their rate of withdrawals, they will wind up running out of money eventually. And going broke slowly is still going broke.

The big picture for retirees is that they should be trying to earn sufficient long-term investment return relative to their spending needs while owning assets sensitive to long-term inflation trends so that unexpectedly higher inflation doesn’t wipe them out. How to do that? The table below gives us a clue.

The period from 1968-1981 was a tough stretch for stock and bond markets and informative for retirees worried about inflation-adjusted investment returns. Highlighted in grey, Inflation (Consumer Price Index) averaged 7.6% per year—think 2021 and 2022, lasting for almost a decade and a half!

Notice the asset classes listed below the US Consumer Price Index in the table above—three of the four bond indexes (only one-year bonds earned a rate of return above inflation), and large cap growth stocks represented by the S&P 500. Now look at the assets above inflation that earned positive real returns: short-term bonds (barely) and small cap and value stocks.

For retirees focused on the big picture, the most sensible investment approach is clear.

Hold more stocks than bonds—their higher long-term expected returns are what you will need to help your money grow faster than you spend it. Don’t make the mistake that Silicon Valley Bank and Signature Bank did within bonds and invest in longer-term maturities. As we saw above, long-term bonds have a lot more risk but not a lot more return than shorter-term bonds. And when unexpected inflation hits, long-term bonds can get crushed. The stock allocation should not be all or even mostly invested in large company growth stocks or just in one country; it should be globally diversified and should hold copious amounts of small cap and value stocks, where expected returns are highest. The added benefit of small cap and value stocks, beyond higher-expected returns and added diversification benefits (see 2000-2009), is that they tend to perform better during periods of higher inflation. We’ve all seen this during the surprise inflation spike in 2021 and 2022.

So, to summarize…

Don’t take unnecessary risks. Don’t concentrate your investments in pursuit of outsized returns. And don’t lose track of the big picture of why you’re investing.

If you can follow these steps and stick to them, you can have a successful retirement investment experience, as opposed to one that blows up on you and causes you to sacrifice your living standard in your golden years.

Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.