SVB and the importance of risk management

Silicon Valley Bank’s downfall holds lessons for investors about the importance of managing risk in investment portfolios

The failure of Silicon Valley Bank sent shockwaves through the financial system as savers and investors scrambled to protect themselves from the fallout. With fear spreading about SVB’s solvency, an old-fashioned bank run ensued. Federal regulators acted swiftly by taking control of the bank and providing an emergency backstop that guaranteed customer access to all of their deposits.

These stop-gap measures have worked to quell the concerns of depositors, shoring up at least some semblance of public confidence in the banking system. But while depositors have been saved from suffering the worst from the fall of SVB, the same cannot be said for investors.

Risk: the permanent impairment of capital

There’s an important difference between bank depositors and investors in terms of risk. Banks function by taking deposits and making loans, which is an inherently risky business. But depositors gain no benefit from the risks that banks take in making loans. Customers collect a defined rate of interest on their deposits, upon which the success or failure of a bank’s loan portfolio has no impact.

On the other hand, investors who hold bank stock have purchased shares of equity ownership in the business of the bank. Stockholders do stand to benefit from the returns generated by loan activity, and they also take on the risk of incurring losses if the bank’s business suffers. The risk-return relationship for equity owners is exactly that—equitable.

This fundamental distinction explains why federal regulators ensured depositors were held harmless while leaving investors to suffer the consequences the market delivered as a result of SVB’s failure. SVB’s share price fell 60% overnight before regulators took control and halted trading in the morning. The remaining holders of SVB stock now face an uncertain future, but it’s likely their investment will be worthless. As famed New York Yankees radio announcer John Sterling often says, “That’s baseball.”

The SVB story highlights the importance of understanding and accounting for the risk-return relationship that comes with investing. One important definition of risk is the potential for permanent impairment of capital—if an investor seeks returns from capital markets, they must also assume some risk. This can be an uncomfortable truism for some investors. But while risk in investments can never be totally avoided, it can be managed.

Managing risk with diversification

SVB’s downfall highlights the importance of two key elements of risk management inherent to Alesco Advisors' investment strategy, the first of which is diversification. Diversification is conventional wisdom for investors seeking to benefit from participation in capital markets. By not putting all their eggs in one basket, investors reduce the impact of losses from a single asset and increase the chance to capture returns from a variety of sources. Diversification minimizes the concentrated risks associated with individual stocks by spreading investments across multiple companies, sectors, and geographies.

Consider the alternative, in which an investor holds a small group of stocks. While this investor might stand to benefit from the potential returns of these concentrated holdings, losses from any one company will have a significant negative impact on the overall value of their portfolio. Even if that investor holds 20 different stocks in equal proportions, SVB’s failure might result in a 5% decline in portfolio value. The risk of losses from a single stock is far more significant to this investor than one with a broadly diversified portfolio.

Contrast that with an investor who sought to manage risk by investing in a low-cost index fund tracking the S&P 500, an index capturing 500 of the most important U.S. companies. SVB would be part of this portfolio too, but a very small part—as of the end of February 2023, SVB comprised just 0.05% (just one 1000^th the weighting of an investor with 20 concentrated positions) of the S&P 500’s value. Diversifying by investing in the entire S&P 500 helps to manage risk so that one company’s failure stands to have far less of a direct effect on the overall value of the portfolio.

The Alesco Advisors investment team typically constructs client portfolios using a number of such low-cost index funds that vary based on company size, characteristics, and geography. We make strategic decisions to favor those that our analysis indicates have the highest likelihood of providing the most attractive returns given the risk involved. This careful data-driven method has proven an effective way of managing risk while providing broad exposure to the potential returns of capital markets.

Managing risk with discipline

The other element of risk management that the SVB failure highlights is discipline. When news breaks about trouble in some part of the market, it often triggers a reaction from investors who feel the need to do something. This sends market values fluctuating, which fuels the reactionary cycle even further.

It’s natural to feel the need to react when uncertainty rears its ugly head. After all, we’re only human, and our hearts and minds are subject to cognitive and emotional biases that often lead to knee-jerk reactions that might not be in line with our long-term goals. When times are good and markets climb, investors often feel better about buying. And when things go badly and markets fall, investors often feel the need to get out and sell. These short-term emotional reactions are a sure recipe for buying high and selling low—the exact opposite of what we know creates returns for an investment portfolio.

Rather than fall prey to the animal spirits that so often cloud our judgment, investors would be wise to develop a long-term plan and stick with it. Or, as the Vanguard Group founder John Bogle is famous for saying, “Don’t just do something…stand there!”

Those who follow a disciplined investment strategy are far less likely to fall into the short-term decision-making traps that reduce returns. The Alesco Advisors team works with clients to develop long-term plans based on risk profiles and investment goals, and we help clients maintain discipline through the toughest times. Doing so allows us to manage the risk posed by poorly timed decisions that can lead investors on a path away from their objectives.

As the fallout from SVB’s failure rankles markets, wise investors are managing risk by maintaining discipline to a long-term plan that incorporates a diversified investment portfolio. For these investors, the question of whether the bank’s collapse was something that could’ve been avoided matters little to investment decisions today—it happened, and there was always a risk that it would. What matters most is continuing to manage risk using a disciplined and diversified approach that best positions investors for what lies ahead.