In this month’s Nick Murray Interactive, a subscription to which I could not commend a higher recommendation, Mr. Murray provided yet another timeless saying.
“Lifetime investing is one part intellectual and nineteen parts temperamental”
I can offer confirmation that this is the case as I consider personal experiences advising my clients over the last 20 years. I also cannot see how this will not remain true for the next 20 years and indeed for the balance of time. To invest successfully for the long term (lifetime investing) requires us to avoid the very real temptation to speculate in the short term as we experience the powerful emotions of greed and fear.
Greed will encourage us to abandon our long-term strategy and invest a higher proportion of our portfolio in equites than is prudent, given our financial goals, when equities have provided handsome (past) returns. Fear on the other hand will scream “sell” when downward volatility picks up and we enter the next inevitable correction or bear market.
We talk about this reality among ourselves and with our clients. We acknowledge the perfectly normal feelings we feel, which are as cyclical as the financial markets, but we know better than to ever allow ourselves to act on these feelings. We know deep down that it will be our behavior which will define success, or failure, as a long-term investor.
In August of 2013 William Bernstein wrote a small book titled Deep Risk: How History Informs Portfolio Design. I found this book by accident as I was searching for something else online about a year ago. I finally got around to ordering the book on Amazon and read it the evening I received it. I am grateful to live in an age in which access to the work of others, with more understanding than I might ever have of the historical record, is almost unlimited. In this book Mr. Bernstein provides some helpful research, interesting talking points, but most importantly perhaps some new language that may aid us as we try to explain to our clients what risk really is.
What comes to mind when you think about deep risk and shallow risk? For me it paints a very clear picture. First it makes it very obvious that there are at least two forms of risk. Volatility is what most in this profession will define as risk, but there is more. Second it helps us to understand that there is a consideration of magnitude when it comes to risk. Some are small (shallow) and some are much more severe (deep). Most investors focus on short-term declines, but that is only one form of risk and it is not the most dangerous form for most.
Shallow risk is a loss of real capital that recovers relatively quickly. Shallow risk is temporary. This does not mean that prices can’t decline significantly, or last a long time, but the important thing to understand about shallow risk is that the decline is not permanent. The most common example would be a correction or bear market. Prices decline 10%, 20%, or more, but these declines are temporary as every economic recession has been followed by a recovery.
Deep risk on the other hand is the long-term, permanent, real loss of capital. This means that after inflation you don’t recover the purchasing power of your portfolio and perhaps never will. The examples he provides for deep risk include catastrophic personal loss of capital, loss of investment discipline and permanent loss of capital defined arbitrarily as a negative real rate of return over a 30 year period. As advisors we must never forget that the only return that matters, financially speaking, is our real return or the return we receive after inflation.
| Deep Risk | Example | Solution |
| Catastrophic personal loss of capital | Death, disability or large legal judgement | Life insurance, disability insurance and liability insurance |
| Loss of investment discipline | Attempts to time the market, selling equities during bear markets or chasing past performance | A good financial advisor is certainly part of the solution |
| Permanent loss of capital – Prolonged hyperinflation | Weimar Germany, post-WWII Hungary, Zimbabwe | Wide equity diversification among international markets with a tilt to value stocks and commodity-producing companies |
| Permanent loss of capital – Prolonged hyperdeflation | Post-1990 Japan | Cash, bonds and gold |
| Permanent loss of capital – Confiscation | Cuba, revolutionary Russia, China | Foreign-domiciled assets + adequate means of escape |
| Permanent loss of capital – Destruction | World War II |
Foreign-domiciled assets (only for local devastation) |
What I believe is most helpful from his work is his recommendation that investors focus on probabilities, the potential cost if they occur and the cost to hedge each potential risk. Living in the United States of America, permanent loss of capital through confiscation is unlikely and the cost to hedge such a risk is too expensive given the low probability. Similar arguments could be made for destruction and hyperdeflation and perhaps even hyperinflation, but what about garden variety inflation?
The most likely source of deep risk for the American investor, in the long-term, is inflation. Even low inflation isn’t no inflation and given enough time, inflation will significantly erode purchasing power. Mr. Bernstein points out that inflation can destroy over 80% of the purchasing power of a bond portfolio over periods as long as 40 years. What does this mean to a 30 year old investor or a 60 year old investor? Both of whom might live another 40 years.
Since some level of inflation is the highest probability, and the cost to hedge this risk is quite low, the portfolios that we recommend and help our clients with remain as relevant today as when I entered this business.
Investors in general are much more focused on shallow risk than deep risk. Shallow risk can certainly lead to a loss of sleep, but deep risk can lead to a loss of sustenance. Equities have been and will remain one of the most difficult asset classes to own in the near-term despite the historical record of good results in the long-term. For these reasons the value of an excellent advisor certain is, and will remain, many multiples of her cost.
It is my hope that my sharing of a small portion of Mr. Bernstein’s work will be useful to you in some way. If you are interested in learning more I encourage you to get a copy of this short but meaningful 50-page book for yourself. I believe that it will help anyone who reads it to be better prepared for the conversations we are having today with our clients. I also believe that discussing risk in these terms, with their associated definitions, will be helpful to our clients during corrections and the next inevitable bear market.