Investor Insights

Meaningful musings from our founder. | Sign up here to stay up to date.

Silicon Valley Bank, and its applicability to you

March 17, 2023

Charles Schwab, both the firm and the eponymous founder, have put out a statement regarding Schwab's financial position. I encourage you to read it here.

A week ago Silicon Valley Bank (SVB) went down in spectacular fashion.

First, they had "Bank" in their name, but everyone in the Valley knew they were a pseudo-bank. 25 years ago I was in their offices in California trying to get a loan from them, and I was dumbfounded at their model: little asset backing requested, they'll take some warrants in the firm, if things go well they'll piggyback along. This sounded like some sort of hybrid VC-firm-bank-thing, and I could see it had a role! But it didn't feel like a traditional bank.

Tech firms are often unprofitable, especially when young, and as the venture capital spigot dried up last year, SVB customers withdrew funds. With a lopsided Treasury portfolio of long-dated bonds, SVB had a mismatch between a short-term demand for funds and a long time horizon on its investments. At some point the CEO actually realized this novice mistake and started dumping his own shares in the bank. As the bank had to sell its Treasuries to meet redemptions, they had to report the loss on those positions, and the tide went out.

Let's look at three things that relate to you, using SVB as a backdrop:

1. Your portfolio is marked-to-market in real time. The values you see are extremely close to the actual cash value of the portfolio were we to sell it all today. There are some rare exceptions in the firm, all of which are due to positions brought in from other firms. These are general private REITs and other complex investment products that are not marked-to-market daily.

So, unlike universities fudging their investment results with the help of private equity shops and venture capital outfits, you know what you own. And unlike Silicon Valley Bank, there is no complex accounting obscuring that fact.

2. Holding a substantial amount of cash above the $250,000 is an error and shouldn't happen. This only occurs at One Day In July for brief periods of time while cash is in a position to move, or at client request. Otherwise short-term Treasury bills serve as a safer short-term store of value.

3. You don't want to create the same time-dating error in your retirement that SVB created in its bond portfolio. SVB was long-dated and had short demand. The risk today is that with interest rates higher in the short duration sector of the bond market, people are shifting assets to shorter positions to meet a need, retirement, that is fundamentally long. Although they don't perceive it as such, this is a risky move, as declining rates could leave them short on cash years from now.

Related to the item above, in terms of matching assets to needs, is the impact inflation will have on a retirement portfolio. As people today shift money from equities to short-term bonds or cash, they are ignoring the inflation-fighting characteristics of businesses. And inflation is a big deal for a retirement portfolio. If inflation stays at a long-term average of 2.5% over 25 years, in real dollars $1,000 drops to $545. But if inflation stays at 4.5% over the same 25 years, that $1,000 drops to $331. This erosion of buying power could affect many Americans facing retirement, and their short-term bonds and cash will exacerbate the issue.

Dan Cunningham

Optionality is good

February 17, 2023

It's the start of the year and that means we have to get real work done in this newsletter. In the late fall it may slide into lethargy and ridiculousness but not now.

Optionality matters in finance. Optionality, otherwise known as freedom, gives you the chance to do something else that is better with your money. It's critical in an economy as well - optionality enables capital and labor flow to better ideas and higher sources of return.

One way that financial firms make a lot of money is to take away your optionality. Things like annuities often have severance charges, and headlining the news recently is the disaster around private REITs. We have many clients who are trying to redeem private REITs (that we did not place them in), and they are finding the boards of these firms are disallowing distributions. When you want your money back, they are saying "No, not today. Our investments did not go well and because we're private there is no market for you to see the real price, but if you redeem we'll have to show you. So can you come back later and fill out a massive pile of paperwork again and we'll do everything we can to slow it down then as well?"

There are some cases where the loss of optionality is clear and compensated. If you buy a bank CD, you likely will get a higher rate than a savings account, because you are giving up the option to withdraw from the CD without a penalty. This is ok, as the bank gives you value in a higher rate and you give the bank predictability and it's clear that this is the exchange. (1)

Here are four examples of optionality loss:

1. Sometimes you can lose optionality inadvertently. For example, if a fund that you own does not have enough liquidity in a severe down market, you may lose money as you trade out of it, particularly if it is a big position. This is known as a "roach motel" in finance: you can enter, but you cannot leave. (2)

2. Other times you can lose optionality through friction. This is one of the favorites of the industry: deny transfers on technicalities or throw enough paperwork at people that they give up. This is called "sludge" and the practical reality is that it stops assets moving to areas of higher return.

3. A third area where optionality is lost is in taxes. You'll notice I don't talk about taxes too much in this newsletter because everyone's blood pressure goes to 180/120 for different reasons, but in this case it's too interesting to resist. When you raise the capital gains tax rate, you restrict capital from finding a more efficient home. So if you were the CEO of a big, old mutual fund company, and you want to keep your profits high, a capital gains rate increase is going to help you and hurt the disruptor. Ideally this rate goes to zero so there is no artificial friction and capital, and hence labor, can move to the source of highest return. But then there is a societal wealth inequality issue to deal with (the capital compounding effect), and that makes things more complicated.

4. A fourth example is a gift card. Take the Starbucks card as an example. Last summer the coffee chain had over a billion dollars sitting unused on its gift cards. Starbucks uses its customers' money as financial float and about 15% of the coffee credits are never claimed. And it's certainly not easy to reverse a gift card.

To the extent things are in our control, we're not giving up optionality for clients. Generally we don't do it at all, but in certain cases where it comes up we want the client compensated.

Dan Cunningham

^{1. It doesn't make much sense to buy CDs today. You can make more money in a 1-Year Treasury, with more liquidity / optionality, and generally a better tax rate, than a CD. So there's really no reason to do it. Talk to us.}

^{2. There are ways we believe we can use the roach motel problem to benefit clients over the long term.}

One thing to think about for your 2023 financial life. It will matter.

January 20, 2023

Several years ago I asked a friend of mine, who ran a division of over 100 Advisors at a national firm, if he had seen any Advisor statistically outperform over the years. "Oh yes," he said, "We had an Advisor who was not a great investor whose clients were among the wealthiest in my division."

Huh?

"For a long time his clients didn't even like him. He was kind of annoying to them, but he did one thing right, and he did it well, and now they are forever grateful."

Proceed.

"He got them to save money. He was relentless about it, almost religious about it, and it worked. You cannot be a capitalist without capital, and generally you can't get capital without saving. Those behaviors injected into an even mediocre investment program produced fantastic results." (1) (2)

So it's January, and it's time to get our school-marm hat on here. The good news is you don't need to make Mark Zuckerberg richer to get your daily dose of endorphins! You can get endorphins from *cutting* personal expenses, and January is a good time to do it.

Then talk to your advisor about what we call "Pay Yourself First," where we set up an automatic savings plan into your investment accounts. I cannot recommend this idea enough; in my opinion it is *by far* the best financial planning approach I have seen. Putting things on autopilot works; it solves many of the behavioral challenges that plague investors. If you do this three years from now it is nowhere near as good, mathematically, as doing it next week. The math of savings with an excellent investment plan compounds geometrically. But you have to do both: save, then invest.

The U.S. personal savings rate dropped to 2.3% last fall, which is near record lows. If this does not rise next month we know either 1. the entire United States is not on this newsletter or 2. They all are, but are ignoring me. Here is the U.S. savings rate chart from Federal Reserve data:

People ask me all the time where I think the markets are going. From the extraordinary investor John Templeton (who, I note, was extremely thrifty himself. Even today his foundation encourages thrift, saving, and investing.):

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria,” he said.

Sentiment matters. The good news is that a lot more people dislike the markets than a year and a half ago. I'm not sure we've reached peak pessimism in either the markets or the economy. But the period where it was fun and appeared to be an easy game is over. Lots of novices got wiped out. As an investor you do not generally want euphoria (unless you are only selling). So the increase in general pessimism is definitely a positive signal for future returns.

Dan Cunningham

<sup>1. This conversation is paraphrased a bit as I wrote parts of it down but don't have the exact wording.
2. We prefer an excellent investment program, but the point is made.</sup>