NWP Monthly Digest | April 2023
Nothing is Truly Risk-Free
I’m a bit frustrated. We spend a lot of time in this space and with our clients describing the concept of “risk.” Nevertheless, it needs to be revisited constantly.
A few weeks ago, the financial world seemed to be unraveling faster than an old sweater. Silicon Valley Bank (SIVB), Silvergate, and Signature Bank of New York all closed down within a few days of each other. We wrote an explanation of this in March that you can read here.
The FDIC came in to backstop the bank’s depositors and guaranteed that everyone would be able to access their money. This, apparently to some in the financial world and on Twitter, was a horrifying display of favoritism, and the term “bailout” was being thrown around everywhere. I don’t want to spend my time this month opining on moral hazard, but I have a hard time calling this a bailout when the stock went to zero, the firm’s executives were all fired, even the bondholders lost a ton of money, and the only people protected were the customers. Seems to me that was the only plausible solution.
So, let’s talk about how this pertains to understanding risk when it comes to your money.
I believe that almost universally, people have their own version of a risk scale in their heads that they use to help them make decisions - a mental model of risk, if you will. Risk, of course, is not binary or black and white. There is no such thing as something being “risky” or “not risky,” and instead, there are shades of risk that progressively increase up and down a scale. In fact, even things that we call “risk-free” still carry risk, and I cannot overstate this…there is no such thing as something that is “risk-free.”
US Treasury Bills/Notes/Bonds are often called “risk-free” assets in the financial world, but that doesn’t mean you can’t lose money in them. Last year, long-dated Treasury Bonds lost a ton of value, and that had a major spillover effect on how Silicon Valley Bank went down (30-year US Notes lost almost 40% of their value in 2022). SVB owned a lot of these securities and was being forced to sell them before they wanted to, and that cost them.
Stocks come with their own shade of risk, as do US Treasury Bonds, and, as our good friends in the banking world have now reminded us, so does the humble bank account (checking or savings).
DEFINING FINANCIAL RISK
The best definition I’ve ever heard of financial risk is “the permanent loss of capital.” For example, if the value of your retirement account goes down in any given year, that is only a minor inconvenience, not a permanent loss of capital. If you invest in a stock, and the company goes bankrupt, that would be a permanent loss.
Let’s be very clear here. The value of your investments in your brokerage or retirement account will fluctuate over a long period of time (just like your house), but that is not “risk” by my preferred definition. However, if you believe “risk” is defined as “I might lose some of my money,” then we have to put the different types of investments on a risk scale.
Keeping things simple, I think you can look at it this way, from less risk to more risk:
Cash in the bank (less than $250k)
US Government Bonds
Cash in the bank (more than $250k)
Corporate Bonds
Real Estate
Stocks (publicly traded)
Private investments in small businesses
There are different flavors of each of these assets, but you get the general idea. You can also quibble with how I’ve ranked them, but the recent banking issues make me feel very strongly that US Government Bonds, if held to maturity, are slightly less risky than bank deposits above the FDIC insurance limit.
Also, each of these broad asset classes has various sub-asset classes that should be treated differently. As defined earlier, longer-term bonds, both government and corporate, carry far more risk than their shorter-term counterparts of the same variety. The stocks of smaller companies tend to be far more risky than larger companies. Technology companies are more risky than utility companies. Etc.
Investopedia’s Risk Pyramid defines it this way:
A SIMPLE DESCRIPTION OF THE RISK ASSOCIATED WITH EACH
Let’s flesh this out a bit more. What kind of risk are we looking at with each of these items?
Cash in the bank (less than $250k)
What could happen?: The bank becomes insolvent and is forced into receivership. All of your money is returned to you under coverage from the FDIC.
US Government Bonds
If you own a bond, that is simply you (the investor) loaning money to the issuer of the bond. In this case, it’s the US Government. The risk that the US Government is going to default on its obligations is very, very, very (insert 100 more “verys”) low.
Example: You purchase a 10-year US Treasury Bond for $10k. You’ve just loaned the US Government $10,000 for them to use for the next ten years, and they will return that initial investment to you when they’re finished. For your trouble, they are going to pay you some interest on that bond, and that would be about 3.5% as of this writing. So, you earn 3.5% per year in interest for ten years, and then you get your $10,000 back.
What could happen?: There is default risk, and the US Government could go under, in which case, you don’t get your money back. Again, this is highly unlikely. However, there is interest rate risk. If interest rates go up on similar 10-year US Treasury Bonds, the value of your $10,000 will go down if you have to sell before the ten years is up. If interest rates go down, the value of your $10,000 will go up if you want to sell before the maturity date.
Bottom Line: Interest Rates Go Up, Bond Values Go Down. Last year, interest rates went up very rapidly, and bonds lost value very rapidly. As is the case with all bonds, the investor will still get their principal investment back at maturity as long as they have the patience to wait.
Cash in the bank (more than $250k)
What could happen?: See above regarding banks. The bank goes under, but the FDIC decides NOT to backstop depositors this time, meaning you only get reimbursed the money up to the FDIC insurance limit of $250k. You permanently lose the rest of your money.
Corporate Bonds
What could happen?: Everything above about Government Bonds holds true with Corporate Bonds, and you need to remember the fundamental relationship of Intereset Rates Go Up, Bond Values Go Down. However, it’s worth noting that you have a much higher risk of default with Corporate Bonds, because companies can go out of business and not have enough cash to pay their bondholders during bankruptcy.
Real Estate
Contrary to popular belief, the price of real estate does go down sometimes. It is not uncommon for clients or acquaintances to tell us that they would “rather invest in real estate, because it’s safer.” However, houses, buildings, and raw land do not always go up in value. In fact, they lose value quite often, like right now for example. Generally, real estate prices reflect the standard supply and demand relationship. Supply goes down relative to demand, prices go up. Supply goes up relative to demand, and prices go down.
Would could happen?: Most real estate is purchased with heavy leverage. When you bought your house, you likely borrowed money in the form of a mortgage to do so. In theory, you can lose more money than you put into a real estate investment due to this leverage, and it also makes real estate prices susceptible to interest rate risks, like we discussed with bonds earlier. Interest Rates Go Up, Real Estate Values CAN Go Down.
Stocks (publicly traded)
The stock market is risky. More than likely, however, it’s not as risky as most average folks think it is. We also have a secret weapon with stocks in that we can diversify our holdings easily. We don’t have to buy just one or two stocks, and owning a broad basket of stocks minimizes the following risk.
What could happen?: For example, you purchase several shares of Enron in the late 90s. Everyone tells you that it’s “the next big thing.” For awhile, the executives at Enron are the darlings of Wall Street and the stock soared in value. You feel like a genius. Except…Enron is doing all kinds of crazy things with their balance sheet, it was not really profitable, they get exposed, and the company goes bankrupt. The stock goes to zero, and you’ve lost all of the money you used to buy those shares.
Private investments in small businesses
Think about one of your best friends asking you to invest in their next great idea. Maybe it’s a restaurant or a software program they built.
What could happen?: The business goes bankrupt before it even gets started. You lose every dollar you invested. For obvious reasons, this type of investment is vastly more risky than buying stocks of publicly traded companies.
WHAT CAN YOU DO ABOUT RISK?
As I mentioned earlier, merely waking up in the morning poses risks. In some way, shape, or form, every activity you conduct throughout the day has some level of risk associated with it. Consciously or unconsciously, your brain works very hard to mitigate those risks so you can function like a normal human being.
The same can be said about your money. You can never eliminate risk, but you can be smart with your decisions and listen to trusted advisors in your life to keep those risks to a minimum.
Noble Wealth Pro Tip of the Month
Let’s talk a little more about FDIC insurance. As it stands right now, the FDIC insures your deposits in banks up to $250,000, but what if you have more than that?
Clients of SIVB had much more than $250,000 in their checking and savings accounts. 81% of the deposits at SIVB were above the FDIC insurance limit. One company had more than $3 billion in its checking account. Crazy, right?
If you insist on or need to carry that kind of cash in a bank, here are a few solutions you should consider to increase and maximize your FDIC insurance coverage:
Have multiple account registrations. For example, you and your spouse can open an account in your name, their name, and jointly. Each account would be insured up to the $250k limit, meaning you just tripled your coverage. Easy peasy.
You can drive around town and open up accounts at every bank available to you. Much less easy, same level of effectiveness. Each account at the different banks is insured up to $250k.
You can utilize a deposit brokering service like CDARS and ICS. This allows you to deposit a large sum with one bank account, and they deploy your deposits through a network of other banks to increase the amount of FDIC insurance you can get without the hassle of driving around town.
Utilize other “cash-like” vehicles such as money market funds or short-term US Treasury Bills.
Noble Wealth Partners is Growing
We are incredibly excited to welcome Sydney Batch as our new Director of Operations and Client Service! Sydney is a proud Colorado native and attended the University of Colorado, Boulder. In her free time, Sydney enjoys cooking, reading, crafting, gardening, and spending time with her husband and family. She has spent the last several years honing her administrative, editing, and marketing skills and is thrilled to be a part of the team.
Things We’re Reading and Enjoying
The Oddlots Podcast with Joe Wiesenthal & Tracy Alloway - by Bloomberg
As the issues in the banking world started to heat up, Joe and Tracy had some amazing guests to walk us through what was happening. I highly recommend this podcast to anyone looking for more information about financial markets and the economy, but they were particularly sharp during the last month with a variety of episodes, some of my favorite listed here:
Betsy Cohen on Tech Investing and How SIVB Failed Banking 101 - March 27th, 2023
Is it Time for Public Checking Accounts at the Fed? - March 23rd, 2023
Where Stress is Showing in the $20 Trillion Commercial Real Estate Market - March 20th, 2023
Dan Davies on What Brought Down Silicon Valley Bank - March 14th, 2023
-Your team at Noble Wealth Partners
“There is nothing noble about being superior to your fellow man. True nobility is being superior to your former self.” Ernest Hemingway