Tuesday, November 5, 2013

William Bernstein on Deep Risk, Shallow Risk, and Investing for the Long-Term

Welcome to this week's video blog made in conjunction with The Wealth Channel at the American College. Today I provide a discussion of William Bernstein's important new e-book, Deep Risk: How History Informs Portfolio Design.

For email readers, the videos never show up in the email, but you can see the video by clicking here.

What now follows is not an exact transcript. It is the written version of what I meant to say above, though as I was not reading from a script, I sometimes veered away from the plan when speaking:

Deep Risk and Shallow Risk

Deep Risk: How History Informs Portfolio Design is the third in a series of e-books by noted financial advisor and historian William Bernstein. This is an investing text which is of the upmost relevance to long-term investors seeking to build a lifetime financial plan. It is a book which focuses on the greater long-term picture for investors.

In the introduction, Bernstein begins by offering an operational definition of risk. Risk is the size of real capital loss times the duration of real capital loss. This gets at the idea that it is a permanent, rather than a temporary, loss of capital that that is most damaging to investors. Magnitude and Duration of loss are both relevant factors. Mistiming the markets, by buying high and selling low, is the most common method whereby an investor sees this risk manifested in their life, as this is the best way to experience a permanent loss of capital. A more disciplined approach to investing is needed to avoid this risk, and this is a key area where advisors can add value for their clients.

This definition allows Bernstein to identify two “flavors” of risk: shallow risk and deep risk. Shallow risk is the loss of real capital which recovers within several years, while deep risk reflects the permanent loss of real capital. It could be defined, for instance, as a negative real return over a 30-year period.

The focus on the book is on deep risk. Shallow risk is important and can be expected to arrive on a somewhat frequent basis, but it can be managed by having sufficient liquidity and discipline to stay-the-course in the face of investing storms.

Deep risk, on the other hand, is a much wilder beast. Over time, it is permanent losses of capital which defines risk, and it becomes apparent that stocks are risker than bonds with respect to shallow risk, but that the opposite is true with respect to deep risk. Throughout the world in the twentieth century, fixed income investors have suffered permanent losses in inflationary storms which equity investors were able to avoid. As Bernstein says, absence of leverage and with sufficient liquidity, retirement savings are not wiped out by too high of standard deviation, but rather by real-world events.

And so, with deep risk, once one has become properly insured to personal vagaries and carefully disciplined with respect to strategy and approach, the four big threats over long horizons are:

1.    Severe and prolonged high inflation
2.    Prolonged deflation
3.    Confiscation
4.    Devastation

The remainder of the book focuses on these four risks in terms of what damage they do, how likely they are to happen, and what strategies provide the best chance to mitigate the threat. Relevant here are the probabilities, the consequences of the hardship created, and the costs of protection.

First in terms of the probabilities that each threat will manifest, inflation is high, confiscation – medium, and deflation and devastation - low

Inflation, though high in probability, has a lower cost for protection.

It is the most relevant to worry about, but also the least catastrophic for a globally diversified investor. It is the easiest to protect against with international diversification, TIPS held to maturity to match spending needs, delaying Social Security, and an inflation-adjusted annuity. A globally-diversified stock portfolio has most effectively protected from the deep risk of inflation, though stocks do exacerbate shallow risk. Meanwhile, unexpected inflation devastates bonds.

Deflation, on the other hand, is the least likely to happen, but it is good for bonds and bad for stocks. Solutions include cash, bonds, and international diversification, as well as gold. But using long bonds and bills carries a high cost if we experience inflation rather than deflation.

As for confiscation and devastation, the best defenses are holding foreign assets and having a means for escape. Confiscation is a likely deep risk as taxes will likely increase in the future.

Bernstein’s conclusion is that the best long-term defense against deep risk is a globally diversified equity portfolio with tilting towards value and precious metals and natural resource companies, TIPS, and potentially some gold and foreign real estate. Because of inflation, bonds become riskier than stocks over long horizons, while shallow risk makes investors with shorter time horizons more vulnerable with stocks. For lifetime financial planning, determining how to transition between deep risk and shallow risk at different points in the lifecycle is one of the greatest challenges facing wealth managers.



  1. In the video, Table 4 ("Stock Returns vs. Inflation") was the first time I have seen the relationship between long term inflation and long-term stock market returns quantified. The cited R^2 of 0.31, which leaves 69% of the variation in stock prices attributable to non-inflation factors, does not suggest to me that stocks are anywhere near the surefire way of keeping pace with inflation that the popular press -- and advisors -- like to tout. Also, is a temporary -- say 1 or 2-year -- upward spike in inflation to be considered shallow risk (which may not be worth bracing against) or is that deep risk?

    1. Thanks, good comment.

      But I think that chart can't be used to make a point about whether stocks protect against inflation. It is show the average real stock returns and average inflation over 112 year periods for different countries. At least average stock returns were always positive. But you are looking for something deeper. I have access to this data set, and I've been meaning to dig deeper into these issues. It's on my to-do list.

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  3. Excellent review. Now go back to recent discussion of risk tolerance measurement and questionnaires which seem to focus exclusively on shallow risk and on an investor's attitude towards (as opposed to capacity to bear) shallow risk. Should financial/investment advisors, as experts giving expert advice, instead of merely reflecting back investor fears, not be telling people how to structure their affairs and portfolios to cope with those risks that most affect their goals?

    1. Excellent way of describing this important issue!

  4. "… and foreign real estate": that's a tricky one. For example, an uncomfortable number of British people have recently found that their real estate in Spain turned out not to be in their secure legal possession. In how many jurisdictions could I be confident of my ownership rights?

    1. I don't think you can be confident of your ownership rights. Confiscation could happen anywhere. I guess it's a matter of diversifying so that all of your eggs are not subject to one country's policy decisions.