Every few years there is a high-profile business implosion, from Long-Term Capital Management (LTCM) in the 1990s to Lehman in the 2000s to the most recent demise of Silicon Valley Bank (SVB Financial Group, SIVB). Behind each of these blow ups are some common themes and lessons we can learn from – and apply – to both our investing and personal financial lives. Here are the key ones:
- As I discussed in the Coastwise February 2023 newsletter (February Newsletter), balance sheets matter. Behind most corporate or personal financial implosions usually exists lots of leverage which dramatically reduces the margin of error for losses. In the case of LTCM, they were leveraged as much as 50-1, so it only took a very small adverse move (a couple percentage points) to wipe out principal. A strong balance sheet with reasonable amounts of debt is a hallmark of all sound financial institutions, so factor this into your investing (and personal financial) decisions. Banks are inherently highly leveraged, so when things go wrong (and SIVB experienced a perfect storm of deposits leaving just as their bond investments were losing money on paper), their demise can be swift.
- A key rule in successful investing is to match your investment type with your time horizon, something I have written about for years. If you need money to pay your rent this month, keep it in cash. If you are saving for retirement in 10 years, then high-quality stocks are a great way to seek returns in excess of inflation. From a financial planning perspective, another way to say this is to match your assets (type of investment – cash, bonds, stocks, real estate, etc.) with your liabilities (your future needs, e.g. to pay a mortgage in 3 months or to buy a new home in 5 years or to fund retirement in 15 years). In the case of SIVB, it turns out they mismatched their assets (the bonds and other investments they held) with their liabilities (customers’ deposits which they asked to get back sooner and in greater volume than expected). To put some basic color on it, let’s say 2 years ago when the 10-year interest rate was closer to 1%, someone deposited $1M into SIVB. The bank then takes that $1M, sets aside their reserve requirement (a small fraction of the $1M), and invests the rest in a 10 year note earning 1.5%. Two years later, the 10-year interest rate is 4%, thus that bond has lost a lot of money on paper. That is not a problem if SIVB can hold the bond until maturity since the underlying bond is very safe, but if the customer wants his money back, then SIVB must come up with the $1M and thus needs to sell that 10-year bond – at a big loss. So, the issue here was not bad investments by the bank per se, rather it was a discrepancy of duration of assets and liabilities. Or from a personal finance perspective, a mismatch of investment type with the investment time horizon. This is a key takeaway from this banking crisis we are currently enduring.
- As discussed in my upcoming book The Compound Code (https://www.thecompoundcode.com) you don’t want to ever end up in a situation financially speaking (i.e. vis a vis your investment portfolio) where a specific outcome must come to fruition in order for a trade or investment to be successful. The reality is that despite financial commentators stating repeatedly that once we get X news (inflation data, a jobs report, etc.) that things will finally be ‘clear’, life – and the financial markets – are never ‘clear.’ Few had heard of – let alone predicted their negative impact on the broad market – the likes of LTCM, SIVB and countless other situations that came out of left field. The fact is that the stock market is made up of hundreds of millions of investors analyzing – or not (usually reacting emotionally to headlines) – thousands of ever-changing variables on a minute-by-minute basis. It is not possible to know, process, or predict short-term stock price movements based on all the available information – let alone what is not readily available (like the fact that someone accidently added a few zeros to a sell order that caused the Flash Crash of 2010 which led to a 1,000 point decline in the DOW in a matter of minutes). Thankfully, as long as you do a few things right, then you can ignore the constant noise and 15-minute headlines. This includes matching your investments with your time horizon (setting aside cash/money market funds/bonds for needs in the next year or two, etc.), staying well diversified, and owning only the highest quality companies, etc. That way, regardless of what happens in the world, you can meet your near- and long-term money needs, and sleep soundly at night.
That is the ultimate job of a Financial Advisor – creating and executing a plan that can allow investors to meet their needs today, tomorrow, and in the future, regardless of what the world throws our way. Because if anything, while the world is becoming less and less ‘clear’ over time, great companies will continue to make money over the long-term which can be the source to cover short-term expenses (e.g. via dividends) and long-term obligations (e.g. via price appreciation) while you go about your life with a peaceful mind.