Monday, December 17, 2018

Deep Risk

When it comes to finances, the definition of “risk” is tough to pin down. We sometimes refer to portfolio volatility as risk, but this doesn’t line up well with what people mean when they talk about stocks or other assets being risky. William J. Bernstein brings us some clear thinking about risk in his 55-page book Deep Risk: How History Informs Portfolio Design, the third of four books in his Investing for Adults series.

Bernstein thinks of risk “in two flavors: ‘shallow risk,’ a loss of real capital that recovers relatively quickly, say within several years; and ‘deep risk,’ a permanent loss of real capital.” “Capital managed for near-term liabilities should be guided by shallow risk, while capital managed for very long-term liabilities should be guided by deep risk.”

This book “provides a framework for thinking about deep and shallow risk as essentially an insurance problem involving probabilities, consequences, and insurance costs.”

“The conventional ‘shallow’ risk of stocks is greater than that of bonds,” but when it comes to deep risk, “the reverse is true.” Inflation can permanently reduce the value of bonds, but the stock market tends to recover from losses. “Stocks protect against deep risk, but exacerbate shallow risk.”

Looking to history, Bernstein finds four sources of deep risk: prolonged hyperinflation, deflation from severe recessions and depressions, confiscation of assets as in communist takeovers or very high tax rates, and devastation from war. He then looks at the different ways of insuring against these types of deep risk.

The author judges inflation to be the most likely source of deep risk and the easiest to insure against. “Your best long-term defense against deep risk is a global value-tilted diversified equity portfolio.” He judges deflation and devastation to be least likely and hardest to insure against.

Past deflation and depressions were mainly due to being on the gold standard, “the result of placing control of the money supply in the hands of gold miners.” “Nations exited the Great Depression in the same order they went off the gold standard.”

An interesting quote: “Stocks, when looked at through a mathematical lens, become riskier with time; but swap out the math lens for a historical one and you get an entirely different picture.” I think that if the math doesn’t match reality, then you’re using the wrong math.

Overall, I highly recommend this short book for those interested in how to protect their wealth from permanent loss.

No comments:

Post a Comment