By Michael Carlisle on March 18, 2016
So, how does history inform us about risk? Most investors are aware that return and risk are two sides of the same coin. Low risk generally equals low relative returns; high risk, higher returns.
William J. Bernstein is a neurologist-turned financial theorist who wrote Deep Risk: How History Informs Portfolio Design (Investing for Adults, Volume 3). Dr. Bernstein argues that risk comes in two forms, “shallow” and “deep,” and knowing the difference between the two can help investors determine what they should be concerned about.
Shallow risk is inevitable, but temporary. If one invests in anything other than cash, there will be price risk. The market value drop can be larger and last longer than an investor wants, but it is by definition not permanent.
Bernstein argues that inflation is the most likely source of deep risk for an investor in the developed western world, and that a globally diversified stock portfolio with some small allocations to natural-resource companies (and gold) plus Treasury Inflation Protected Securities (TIPS) are the best insurance against inflation. Cash, long bonds and gold offer the best protection against prolonged deflation. However, due to government’s propensity to “print money” deflation has rarely occurred in the western world since “fiat” currencies were decoupled from gold beginning in the 1930s. Confiscation (usually by revolutions) and devastation (generally from wars) are (thankfully) rare and can only be addressed with foreign-domiciled assets.
In addition, Dr. Bernstein touches briefly on one other deep risk factor— investor behavior. Panic selling into a deep (but temporary) drawdown in the markets will convert “unrealized” temporary losses into “realized” permanent loss of capital.
That is why it is so important to understand the sources of deep risk, allocate the appropriate assets to insure against such risks, and build sufficient liquid reserves to preclude the need to sell into a downturn. It has been my experience that investor behavior can result in more loss of capital than almost any other risk factor because it converts a “temporary” (admittedly powerful) emotion into a permanent reality.
How then should an investor behave? I would submit, behave as rationally as possible in the face of what financial history tells us about how to manage portfolio risks, taking into consideration the age and station of life an investor has attained.
Younger investors should navigate by what Mr. Bernstein calls the “deep risk lighthouse” while older individuals should navigate by the “shallow risk lighthouse.” The early retiree faces the more challenging task of managing both shallow and deep risk, usually over a 20 to 25 year time horizon. There are strategies for the near- or early-retiree using a combination of cash, low-risk bonds and diversified stocks that rationalize the risk factors they face in an attempt to provide the funds necessary to maintain their standard of living.
Investor behavior is a particular interest of mine. If you want to talk about this, or investing in general, let’s visit!
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