The sudden collapse of Silicon Valley Bank highlights an important wealth management principle. Whether you manage your wealth on your own or hire an outside advisor to assist you, your first priority must be to understand the risks you face. Once you understand your risks, you can take steps to mitigate those that are unwanted. Failing to deal with your portfolio risk, makes you more of a gambler than an investor, and a rather sloppy one at that. Silicon Valley Bank made a sloppy bet on interest rates and they lost billions.
Please do not misunderstand. I am not saying that all risk should be eliminated. Some degree of risk is necessary in any investment program. However, professional investors understand that financial markets are generally efficient when it comes to risks and rewards. In most situations, markets will not pay you for risks that can be easily offset or avoided.
Risk comes in many different forms and may be defined and measured differently depending on who you ask. Some risks are to property, others are to the person. Some are insurable, others are not. A wise wealth manager will keep an eye on all of them. For today’s purposes we are going to limit our discussion to financial risk, or the risk that an activity or event could lead to a permanent loss of wealth.
Not every risk is equal in its likelihood of occurrence or in the severity of loss it might inflict. However, just because a risk is rare or has never been experienced, doesn’t mean it can be ignored—a lesson underscored by the rapid demise of Silicon Valley Bank and Signature Bank. Nassim Taleb made a personal fortune writing a series of five best-selling books about what he termed “black swan” risks. We don’t have room to get into his ideas in this column, but I highly recommend three of his books to the interested reader: The Black Swan, Fooled by Randomness, and Antifragile.
In the meantime, here are some of the more common risks you should look for in your portfolio.
Default risk – Remember that money your brother-in-law borrowed from you 15 years ago? That was default risk, or the risk that you would never see that money again. Any time you lend money, whether by making a loan, buying a bond, or depositing money in your local bank, you take the risk that the borrower will default and not repay you.
Default risks can be mitigated, if not eliminated. For example, Within certain limits, FDIC insurance protects against default risk in bank deposits by shifting the ultimate credit risk on deposits from the bank to the full faith and credit of the United States.
Bond investors, on the other hand, mitigate default risk by analyzing the credit risks associated with a particular bond issuer and diversifying their holdings. Since most individual investors do not have the resources to perform this kind of analysis, they are usually better off investing in bonds through a mutual fund or exchange-traded fund.
Going-concern risk – if you buy stock in a company that fails, you will suffer a permanent loss of wealth. We call this “going-concern risk.” As with default risk, the most effective way to mitigate going-concern risk is to diversify your holdings across several high-quality companies. Since most individual investors do not have the skill or resources to properly analyze the viability and future prospects of individual companies, they are typically better off investing through a mutual fund or exchange-traded fund.
Liquidation risk – portfolio assets are often used to fund other purposes such as living expenses for retirement or college expenses for a child. If portfolio withdrawals force you to liquidate investments at a time when the value of those investments is under pressure because of short-term market volatility, you are experiencing “liquidation risk.”
Liquidation risk can be managed by how you structure your portfolio. Because the effects of equity market corrections generally dissipate over a four-year time period, we try to keep four years’ worth of planned withdrawals invested in short-term bonds. This in only a rule of thumb. The correct structure for your personal situation may be very different, but I encourage you to review your exposure to liquidation risk with your financial advisor.
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Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.