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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