Learning from Failure

IN THE WEEK SINCE Silicon Valley Bank (SVB) failed, a debate has raged: Did the government do the right thing when it decided to guarantee all of SVB’s depositors, including those that exceeded FDIC limits?

On one side of this debate are those who view the government’s action as an inappropriate and undeserved bailout. In an article titled “You Should Be Outraged About Silicon Valley Bank,” The Atlantic argued that the bank’s failure was the predictable result of incompetent risk management. Critics further cite a reality of human nature: If bank executives are confident the government will step in to pick up the pieces every time something goes wrong, they won’t be as careful in managing risk. Economists call this “moral hazard.”

On the other side are those who think the government did the right thing. They point to the fact that the crisis was quickly contained, and at a cost that will likely be insignificant. Not surprisingly, the loudest voices in this camp came from Silicon Valley. Before the government stepped in, one venture capitalist warned of a “startup extinction event” if SVB were to fail. He urged the Federal Reserve to, as he put it, “bearhug the situation,” but also argued that this should not be characterized as a bailout and would not create moral hazard.

For better or worse, the crisis was contained, and everyone is now breathing a little easier. But it’s worth asking what we can learn from this incident. I see five lessons:

Rule No. 1 of investing. In a letter to my clients last weekend, I commented that, when it comes to our finances, there’s always something to worry about. Beyond the stock market, which everyone understands to be volatile, investors have lost sleep over investments which are usually perceived to be far safer.

For instance, three years ago, at the start of the pandemic, there was widespread worry about municipal bonds. Earlier this year, with another government shutdown on the radar, investors began discussing the unlikely possibility of a default on Treasury bonds. And despite their infrequency, the failure of SVB, along with that of Signature Bank, serves as a reminder that even the safest instrument available—a bank account—can carry risk.

Fortunately, there is a solution, and it’s an easy one: diversification. It’s not only the simplest tool in an investor’s toolbox, but I believe it’s also the most effective. Back in 2018, I suggested several ways to diversify so as to protect against so-called unknown unknowns. As an example, I cited the 2003 blackout that hit New York City. Among the effects, ATM and credit card networks went offline. For those without cash to purchase groceries, it was a difficult situation. While it was temporary, these are the sorts of black swan events that can occur. That’s why I recommend diversifying along as many dimensions as possible to guard against whatever the next financial curveball turns out to be.

Rule No. 2 of investing. When it comes to managing our finances, many things are outside our control. That’s why it’s even more important to control what we can. SVB customers whose balances exceeded FDIC limits are lucky the government came to their rescue, but they wouldn’t have needed that support if they’d taken even the simplest of steps.

Have more than $250,000 in an individual account or $500,000 in a joint account? The easiest thing is to open an account at another bank to double your coverage. I know folks who maintain three or four separate accounts. It’s not hard, and yet there are solutions that are even easier. You could open an account with a bank that participates in the IntraFi Network. If you need to maintain large cash balances, an IntraFi bank will automatically split your cash up among multiple banks, with none exceeding FDIC limits. From the customer’s perspective, it’s as easy as opening a single account, but it provides virtually unlimited coverage. A service called Max provides a similar solution, but with an added feature: As banks raise and lower their interest rates, Max will automatically shift balances around to maximize customers’ income.

Those are two simple bank-based solutions. If you don’t mind a tiny amount of inconvenience, you could move excess cash into a brokerage account, where you could invest in a money market account that holds only Treasury bills. That would provide both more interest and essentially unlimited government backing.

Not so smart. In finance, there’s the concept of the “smart money.” I’ve never liked this term, and the Silicon Valley mess illustrates why. Even people who are knowledgeable and experienced—like SVB’s clientele in the venture capital community—can make mistakes.

In the aftermath of SVB’s failure, some have pointed out that the bank’s risks were hiding in plain sight. One observer, for example, was making the case on Twitter as far back as January. The average banking customer might not have followed his arguments, but certainly venture capitalists should have been paying attention. The implication: The notion of smart money is a myth.

Recency bias. Why did so many of SVB’s customers ignore the risk when their accounts exceeded FDIC limits? If you asked them, my guess is they’d say that the risk of a bank failure seemed remote—like the sort of thing that might have happened back in the 1930s, but not today. That complacency is understandable. Outside of recessions, bank failures are rare. But this episode reminds us to be careful of what psychologists call recency bias. Just because something hasn’t happened recently doesn’t mean it won’t.

Reputation. For decades, Silicon Valley Bank was “the” bank for Bay Area elites. Similarly, First Republic Bank, which is teetering, has cultivated an image as the banking destination for the well-heeled. Its ads feature photos of sophisticated-looking customers, including tech founders, heirs, artists and the like. But outward appearances were deceiving, as we’ve all now learned. Silicon Valley and First Republic, it turns out, were much better at marketing than at banking.

With the benefit of hindsight, we know this. The problem, though, is that P.T. Barnum-like characters inhabit every industry, and they’re difficult to identify in advance. Last year, I described “the storyteller’s toolbox,” with some recommendations on how to spot—and hopefully avoid—financial hucksters. Ultimately, though, I’ve only found one solution to this problem: to keep one’s financial life as simple as possible.

That’s why, whether an investor has $30,000 or $30 million, my advice is the same—to maintain a simple portfolio of low-cost index funds and Treasury bonds, and to assiduously avoid anything more complicated than that. That, I believe, is the best formula for virtually every investor.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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