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Building a Barbell

Adam M. Grossman

IN THE WEEKS SINCE Silicon Valley Bank (SVB) disintegrated, there’s been a fair amount of post-mortem analysis. In the end, two factors drove the bank’s demise.

First, SVB’s customer base was concentrated among venture capital-backed technology companies. Because of that, nearly 90% of deposits topped the FDIC threshold and were thus uninsured.

Second, owing to 2022’s rise in interest rates, SVB’s bond portfolio took a hit. That sparked concern about the bank’s solvency, prompting depositors to overwhelm the bank with withdrawal requests.

Those explanations are accurate, but they’re also very specific to the management of a bank. There is, however, a more general—and very valuable—lesson we can all learn from the Silicon Valley failure. We can start by taking a closer look at the problem the bank had with its bond portfolio. What exactly happened?

As you’re probably aware, bond prices decline when interest rates rise, and vice versa. That can be a serious problem for those with sizable bond portfolios. But fortunately for institutional investors like SVB, there’s a way to mitigate the risk posed by rising rates: Bonds can, in effect, be insured using an instrument known as an interest rate swap.

When rates rise, these swaps provide a hedge against losses, and Silicon Valley Bank did indeed employ swaps. As of year-end 2021, it had hedges in place to protect $15 billion of the bonds on its books. During 2022, however, the bank decided—for reasons that aren’t completely understood—to drop nearly all those hedges. By the end of 2022, hedges remained on just $560 million of its bonds.

That move alone might not have doomed SVB because not all bond portfolios require hedging. It depends what a portfolio looks like. But as you might guess, SVB held precisely the types of bonds that did need protection. Why’s that?

As noted above, bond prices drop when interest rates rise. But this effect is magnified for longer-term bonds. All things being equal, a 10-year bond will lose much more than a one-year bond when interest rates rise. That was the heart of SVB’s problem. It had positioned a sizable chunk of its portfolio in bonds maturing beyond 10 years. It was the losses on that portion of the portfolio that were the bank’s undoing.

In other words, SVB had a bond portfolio that was risky—and that it knew was risky—but nonetheless decided to eliminate virtually all the protection it had previously put in place. That, of course, was in addition to its concentrated depositor base. While no one can be sure, I suspect SVB might have survived if it had been carrying just one of those risks. But in combination, SVB’s managers had no place to turn when things didn’t go their way.

As individual investors, what can we learn from this? In my view, the lesson is clear: It’s okay to take risk, but if you’re going to take risk in one area, be sure to have sufficient protection elsewhere to offset that risk. What does this look like in practice? Below are five examples.

Portfolio construction. The stock market has been a reliable way to build wealth—but it’s also volatile. How can you offset that risk? By doing exactly the opposite of what Silicon Valley Bank did: Instead of taking unnecessary risk with long-term bonds, stick mostly with short-term issues, those with durations of three years or less. You could purchase individual bonds or opt for funds like Vanguard Group’s short-term Treasury ETF (symbol: VGSH), its short-term municipal bond fund (VWSUX) or its inflation-protected bond ETF (VTIP).

In the investment world, this approach is referred to as a barbell, with allocations at either end of the risk spectrum helping to balance each other. The more weight you have on the riskier end of the barbell, the more you’ll want to add to the safer end. In SVB’s case, it had far too much on one end and not nearly enough on the other. As an individual investor, you want to do the opposite.

Does that mean you should never own intermediate- or long-term bonds? Total bond market index funds, which are quite popular, carry an intermediate-term maturity. It’s okay to own a fund like this—and it certainly wouldn’t be as risky as what SVB owned—but these funds do still carry material risk. Last year, they saw double-digit losses, while short-term funds like those mentioned above experienced losses of less than 5%. For that reason, I recommend that short-term holdings make up the majority—up to 80%—of a bond portfolio. You could then add a modest amount of intermediate-term holdings. For individual investors, I see no reason to own long-term bonds.

While working. How should you allocate your portfolio during your working years? I recommend thinking about a portfolio in segments. If you’re 10 or more years from retirement, I think you can take as much risk as you’re comfortable with in your retirement accounts—up to 100% in stocks. But taxable accounts are a different story. They serve a critical purpose, providing a backstop in case of job loss or an unexpected expense.

For that reason, a taxable account should almost always be allocated more conservatively than a retirement account. How conservatively? To decide, you’ll want to assess the likelihood of a rainy day. This is specific to each individual. What’s most important, though, is that you build a barbell with your retirement and taxable accounts. Less risk in one allows you to take more risk in the other.

Pension benefits. If you’re in the lucky minority who’ll receive a traditional pension—especially a government pension—typical asset allocation rules of thumb probably won’t apply. Most people, for example, reduce their stock holdings as they get older. But if your pension, together with Social Security, will meet most of your retirement expenses, you can afford to position your portfolio much more aggressively than someone without a pension.

Of course, you should never take more risk than your stomach allows. But if you expect to spend only a small amount of your savings during your lifetime, it’s logical to allocate your portfolio with an eye toward the next generation. If you have 40-year-old children or 10-year-old grandchildren, or plan to leave a large portion of your assets to charity, it would make sense to invest more aggressively than most others your age.

Social Security benefits. Suppose you’ve done the math and decided you want to wait till age 70 to claim the largest possible Social Security benefit. I think that makes sense for most people, but it does pose an asset allocation problem.

If you retire at 65, with five years to go before starting Social Security, what should your portfolio look like on the first day of retirement? Should it reflect your initial, higher withdrawal rate, or the reduced rate that will begin five years later? Mike Piper, an accountant and personal finance writer, offers a solution: He suggests building a “bridge” to Social Security.

Say your benefit at age 70 will be $40,000. Piper suggests setting aside $200,000 (five years x $40,000) and holding those dollars in either cash or short-term bonds. Since those funds will provide a nearly risk-free bridge to Social Security, you can then allocate the rest of your portfolio more aggressively, reflecting your future, lower portfolio withdrawal rate once Social Security begins.

Private funds. What if you have private fund exposure, such as a venture capital, private equity or hedge fund? Is there a way to offset this risk? When it comes to private funds, I’m sometimes accused of being the Grinch. But here’s my approach: In looking at the sustainability of a portfolio, I ask what would happen if the value of any private fund holdings went to zero.

Why such an extreme position? Unfortunately, I’ve seen it happen more than once. When it comes to private funds, there’s simply a much lower level of transparency and investor protection. How can you offset this risk? My personal approach is to avoid investments like this altogether. But if you do choose to invest, a reliable way to offset this risk is by sizing the investment appropriately. Invest an amount that’s large enough to make a difference if it does well—but not so large that it would cause a real problem if it doesn’t.

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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Stan Blue
1 year ago

I would just add that if one has more money that one could possibly use (planning to leave money to legacy, for example) one should seriously consider the implications of a step-up basis upon death in taxable accounts. So, in that case load up on stocks that pay minimal dividends and have high expected return (which likely requires that they have high volatility).

Nick M
1 year ago

I mostly agree with your points, but I disagree about the taxable account being a more conservative asset allocation. If someone already has an emergency fund, why add an additional layer of conservative investment? This just seems like mental accounting, since one could accomplish the same by instead having the same asset allocation everywhere and simply increasing the emergency fund. That said, I do plan to keep short term bonds in taxable and intermediate bonds in retirement accounts.

I use my taxable account to fill in the gaps caused by the limited options of my 401k. I suspect many people would be well served by doing the same.

I suppose this also comes down to what people mean by asset allocation. I find it easier to create separate buckets for specific expenses, like an emergency fund or social security bridge; and view everything else as one single portfolio composed of all other assets. For me the idea of having different asset allocations in different places is just unnecessary complexity.

Having 80% in short term also seems a bit excessive, though on balance it’s probably better than holding only intermediate bond funds. Holding 1/3 to 1/2 in short term would leave enough in intermediate bonds to provide diversifying volatility to stocks, for those periods where (unlike today) bond correlations are actually negative.

Randy Starks
1 year ago

Exactly, the barbell strategy today is a good one. Shorten up on your bonds, add a money market fund, and de-risk your stock portfolios, which include REITs. And add some type of general commodity, Gold or Silver ETF, your choice until the Debt Ceiling issue is resolved.

PS – Congress will raise the debt ceiling, which just kicks the can down the road. U.S. Debt is unsustainable and fiscal policy is out-of-control.

De-dollarization is in full bloom around the World. Watch out for the BRICS+, the PetroDollar is dead.
https://www.aier.org/article/de-dollarization-has-begun/

Last edited 1 year ago by Randy Starks
David Johnson
1 year ago

As is the case with a high number of posts on this site that I agree with, I find this one to be extremely well reasoned.
Seriously, though, this is a cogent explination of a rational way to look at portfolio risk while factoring in time horizons applicable to the goals of the holdings.

Harold Tynes
1 year ago

Those of us of a certain age see similarities of SVB and Signature to the S&L debacle of the 80’s, lending long and borrowing short is a recipe for disaster. I’ve used a 7 year fixed income ladder with tax exempt or taxable in my taxable accounts. It depends on after tax rates and availability. My non-tax accounts I have TIPS. Every year I have 1/7 of the fixed portfolio mature and I buy out 7 years again. I’ve done this for 20 years and it keeps me constantly in the market without losses.

Kenneth Tobin
1 year ago

When working I always bought LONG TERM MUNIS with hi yields knowing I would keep them to maturity. When 10yr CDS were paying 5-5.5% about 15 yrs ago I loaded upon them. My mentor said rates cannot go lower and they went to zero.Just bought 5yr CDS at 5.45%; If 10yr CDS go above that I am a buyer

Rob Thompson
1 year ago

Adam,

I always enjoy and learn something new from your articles. I have a question and a warning for others:

Aren’t bonds on the long end (i.e TLT) better in a recession?

Regarding Private Funds: I had diversified in a fund at Yield Street. Then a year or so later had the desire to simplify the portfolio for my better half. I went to close this account and discovered something that I had missed in the prospectus. I had to wait until quarterly periods when they permitted the selling of shares back to the firm. And there was no guarantee they would buy back all of the shares you proffered. I’ll just say that I’m still working on getting that modest investment out.

Cheers,
Rob

M Plate
1 year ago

I would give this a thumbs-up, but the site won’t let me today.

Jonathan Clements
Admin
1 year ago
Reply to  M Plate

In recent weeks, there have been periodic problems with commenting etc. I’ve twice asked the site’s web developer to look into the problem and he’s made various tweaks, but obviously without full success. As best I can tell, readers who have problems are usually using some version of a Microsoft browser. Often, it they use another browser or simply refresh, the problem goes away. I wish I knew how to fix the problem, but — alas — I don’t.

Nate Allen
1 year ago

In general, if I ever have any sort of trouble with absolutely anything on any website that should be working, the first thing I try is using a different browser. 9 times out of 10, the problem is resolved.

Last edited 1 year ago by Nate Allen

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