What a month that was. March 2023 will be remembered as the month with the swiftest bank collapse in US banking history.
By now, most of us have read about the what, the who, the how, and the why leading to the downfall of Silicon Valley Bank (SVB). Despite turmoil in the banking system — which also included the failure of Signature Bank and the rescue of Credit Suisse — the Federal Reserve raised interest rates another quarter of a percent in its continued quest to combat high inflation and tame a hot economy. And investors shook off all of this news, as all three market indices gained for the month and for the first quarter of the year. Year to date (as of Monday, April 3), the S&P 500 is up 6.94%, the DJIA up 1.13% and the NASDAQ up 15.65%.
The most important thing
SVB’s failure underscores just how important diversification is when it comes to managing risk and investing under uncertainty. (If you missed her column last week, Ellevest CEO Sallie Krawcheck unpacks banking risks in plain English.) I’m not just talking about diversifying cash savings over $250,000 by spreading it across multiple banks. Holding your cash savings (under the limits) across multiple banks doesn't just mitigate risk — these amounts are guaranteed by FDIC insurance. However, when it comes to investing, unfortunately there are no guarantees.
Investing is inherently risky. And as investors, it can be daunting to identify and understand the many kinds of risks across our portfolio. We can’t eliminate it — if we want returns, that is — but we can mitigate and manage them to help achieve successful outcomes over the long term.
The way to do this? Diversify everything. Everywhere. (“All at once” optional.)
Diversification across asset classes and investments allows us to mitigate many kinds of risk associated with investing — interest rate risk, inflation risk, credit risk, political risk, and concentration risk, to name a few. It’s a smart way to protect against the unknown and the unpredictable, two “features” that are inevitable in investing. There’s only one thing of which I’m completely certain when it comes to investing: No one knows for sure what will happen next. If we did, we could put every last cent we have in whatever will perform the best in the future, no risk, no diversification, all returns.
Concentration risk — the $5 term for “too much of one thing” — is a common and sometimes hidden risk we see in client portfolios. It can result from something great, like an IPO; or it might creep up on you unintentionally if you’ve been holding a particular stock that was once a fraction of your portfolio but has since grown into a much larger percentage. (That’s why regular rebalancing is so important!)
One of the big contributors to SVB’s collapse was how concentrated its depositor base was. You may have read that SVB’s customers were primarily entrepreneurs and start-up companies, many operating in the technology sector; many, if not most, of these customers were young, not-yet-profitable businesses. SVB lacked the deposit-base diversification that makes so many larger banks so (relatively) stable. Think about the people who bank with one of the biggest US banks: millions of everyday retail customers, from all walks of life and occupations; small businesses operating in different industries and geographical regions; large private and public corporations; and probably even many start-up companies. With such a wide range of customers, it’s much less likely that a single, specific risk would affect all of those customers in the same way, at the same time. But when concentration risk is a factor, success or failure is highly dependent upon a single factor or two — like a pullback in venture funding or rising interest rates.
Visualizing the effects of diversification
The chart below helps illustrate how valuable asset class diversification can be. Commodities (think oil, wheat, natural gas) were the only sector that saw positive gains in 2022. But so far this year, that same sector has become the worst performing. That black line through the middle of the chart follows the yearly performance of a portfolio of 60% diversified stocks and 40% diversified bonds. As you can see, it’s never been the best performer, but neither has it been the worst. And in investing, minimizing big losses and having consistent performance has historically led to successful outcomes over the long term.
As we enter a market environment we’ve not seen in decades — one characterized by high(er) interest rates, high inflation, and heightened geopolitical risks (Russia-Ukraine conflict, China-US tensions, to name a couple) — it’s more important than ever to diversify risk, in every possible way, and at every level. Having an allocation to stocks, bonds, and alternatives is a great start.
What’s even better is further diversification within each of those allocations. (At Ellevest, we do this for you.) For equities, it means having large and small stocks, as well as US, European, Asian, and emerging market stocks. For bonds, it means owning US Treasuries, municipals, investment-grade and below-investment-grade bonds, all with different maturities. For investors with access to alternatives, diversifying across a range of different alternatives that have low correlation with stocks and with each other can provide even greater protection for your portfolio.
Finally, perhaps the hardest but nevertheless important risk to diversify against: lack of diversity, especially as it relates to the teams who are making the investment decisions. While diversity is rarely mentioned in conversations about investing, research shows that it should be. Diverse teams perform better than non-diverse ones, are more prudent risk managers, and deliver higher returns. With 98% of asset management firms currently owned by white men, the investing industry itself suffers from a serious concentration risk. When you have homogenous teams making investment decisions, they’re more susceptible to groupthink and thus may miss key opportunities — and overlook potential risks. That’s why at Ellevest, we work hard to invest with as many diverse investing teams as we can.
Ellevest portfolios are broadly diversified, and as markets and the economy change, no single risk or slipup should ever be able to derail your portfolio. That’s why identifying and mitigating risk on an ongoing basis — instead of chasing returns — is so essential to our ongoing investing approach. Your long-term investing success depends on it.
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