Concentration Builds & Destroys Wealth
Key Takeaways
The stock market is a tried and tested way to build wealth and outpace inflation — the tradeoff? Volatility and risk.
You can manage it by diversifying your holdings and allocating to a broad global allocation to reduce some of that risk, then ride through the storms when they come.
Including bond allocations can help to further dampen the ups and downs. Rather than focus purely on returns, we approach bond allocations in a portfolio like a see-saw, proportionally allocating bonds at each end of the duration spectrum to help to balance the risk out.
Know what you own, and know why you own it.
Ever since the mini-bank crisis in March 2023 where Silicon Valley Bank (SVB) disintegrated, there has been quite a lot of commentary and analysis on what happened. In a nutshell, there were two main drivers of SVB’s collapse.
As its customer base was mainly venture capital-backed technology companies, over 90% of its deposits were large and exceeded the FDIC (in Singapore we have the SDIC) threshold, and were thus uninsured.
Thanks to the rapid rate hikes in 2022, SVB’s bond portfolio suffered losses. As you know, bond prices go down when interest rates go up, and vice versa. Like most investments, this will be a problem if you need to sell at short notice to free up capital.
However for sophisticated and large investors like SVB, there is a way to hedge the risk from rising rates — by using something called an interest rate swap.
For whatever reason, SVB removed a lot of their hedges in 2022 and ultimately suffered from it. However, not every bond investment or portfolio requires hedging as it comes with a cost. It also depends on how your investments are allocated. The farther out the maturity of your bond investments, then the more it is affected by changes in interest rates (side note for investors who hold perpetuals, which have no maturity date!).
In this instance, SVB held exactly the type of bond investments that required protection with a large chunk of its holdings in long duration bonds (see chart below).
Growing Your Wealth
The stock market has been a good and academically proven way to build wealth and outpace inflation. The downside is its volatility and risk. So how do you offset some of that risk?
For investors who can stomach the volatility of stocks, diversifying your holdings and allocating to a broad global allocation removes some of that risk.
For investors who cannot stomach the full volatility of stocks, then diversifying your holdings further to include bond allocations help to further dampen the ups and downs.
And for your bonds allocations, there are advisable protocols to follow. Don’t do what Silicon Valley Bank did — don’t hold the highest yielding bond issues (long-term and lower quality) just because the returns are the highest. Instead hold at least half of your bond allocation in short-term issues (those with durations of five years or less) and the rest in intermediate (durations of 6 to 10 years).
It is unlikely you want to hold a bond with a multi-decade duration. Think about it from the perspective of lending a friend a sum of money — and he or she says they will pay you back in 20 years. Doesn’t sound like a good deal right? But yet, many investors still chased after perpetual bonds which basically meant that the borrower had no set timeframe to return back your money.
Safeguarding The Process
Diversifying risk and creating a proper asset allocation is not a new concept in investing but is something that investors do forget or neglect after a while. That is why the bulk of the core portfolios we create have a certain type of allocation (As mentioned in a previous article What if you retire or need income during a bear market (part 1). For instance, our bond allocation has a mini-barbell type approach — with allocations straddling each end of the duration spectrum to help to balance the risk out (see below).
Just like a see-saw, the more weight you have on the riskier end of the barbell, the more you’ll need at the safer end to counteract any possible risks. But does this mean you should shy away from all long-term bonds? Not unless you have a properly designed plan and asset allocation which was built to cater for what you wanted to achieve.
Investing does not mean trying to max out whatever your money can do for you. It has to do with how best you can utilise your assets, balance competing opportunity costs, and make them grow for you in a manner where you can sleep well at night, for all the nights to come.
If you want a second opinion on whether your investments are set up in the right way for you, come and have a chat with us.
