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Investors: Should you worry about deep risk or shall


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Even if you’re only an investor because of your 401(k)s or IRA, you should know by now that stocks are riskier than bonds, which are riskier than bank CDs.


You know, at least vaguely, that the value of your investments is affected by rising prices, economic downturns and unexpected world events.

William Bernstein -- Portlander, retired neurologist and one of the most influential investment authors of our time -- has thought a lot about risk and how it impacts investors differently. He recently laid out his conclusions in a self-published e-book called “Deep Risk: How History Informs Portfolio Design.”

It’s the third in a series of e-books Bernstein has written called “Investing for Adults” -- adults meaning experienced investors. But the latest e-book offers lessons for everyone.

Bernstein, author most notably of “The Intelligent Asset Allocator,” has simplified all investment risks into two categories – shallow risks and deep risks.

The risks I cited above are all shallow risks. They can cause investors to lose quite a lot of money, but only for a few years before the investments recover. By that definition, our 2008-09 financial crisis, bad as it seemed at the time, was a shallow risk.

Deep Risk Cover.pngView full size

Deep risk is a long-term loss of real money. We’re talking 30-years-plus, the span of a career or retirement. It’s like what happened to the value of long-term U.S. Treasury bonds between 1941 and 1981, Bernstein notes. They lost 67 percent of their real value, that is, adjusted for inflation, which soared in the 1970s and early ‘80s.

Stocks suffer in periods of shallow risk. But historical data across multiple countries show that stocks actually protect against deep risk.

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, in research titled “Triumph of the Optimists,” found that across 19 nations and 112 years, stocks significantly outperformed bonds.

Here’s one key reason why. When a person owns a stock, they own a piece of a company that, presumably, owns assets and produces something of value that can be priced as prices increase. In times of rapid inflation, those features seem valuable.

Not so much bonds. They are a promise by the issuer to repay the money you’ve loaned, with interest. If prices rise at a faster rate than the interest rate on your bonds, you’re actually losing buying power. Nobody wants to buy your low-paying bonds, either. They’d rather buy bonds paying a higher interest rate. So your bond values decline.


william_bernstein.JPGView full sizePortland author William BernsteinJane Gigler

“Inflation absolutely destroys bonds,” Bernstein explained in an Oct. 1 interview. “Stocks actually do fairly well during inflation. They’re seen as a store of value. They’re seen as a claim on real assets.”

There are four key deep risks that threaten investors. The first and most common is unexpected and long spell of excessive price increases, or hyperinflation. That’s happened in our lifetimes in Brazil, Argentina, Peru and Israel. In Brazil, prices more than doubled on average each year between 1961 and 1996.

A second deep risk is a long spell of price decreases (deflation or a depression), such as our nation’s Great Depression or Japan’s more recent lost decade.

Third is the outright confiscation of assets by governments, such as what happened in Russia after the end of the Soviet Union. Fourth is devastation, such as the damage done in Europe during World War II or a nuclear Armageddon.

There’s not much the average retirement saver can do about those last two risks, Bernstein says. There’s also little chance of either happening in the United States, even with elected leaders who insist on governing by shutting down government.


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Recent bond returns suggest many – but not all – investors need to be concerned about deep risk.

Here’s why. Bond values decline when interest rates increase. Interest rates have been declining since 1981. While the Federal Reserve has indicated it plans to keep rates low through 2015, they will likely go up at some point soon.

That’s what happened over the past 15 months. The overall bond market has declined in value this year through Oct. 3 by about 3 percent. Long-term bonds fared even worse. Most CDs also are losing money when you consider that their returns are lower than increases in consumer prices (inflation).

Vanguard’s Total Stock Market Index (VTSMX) is up 21 percent year-to-date through Oct. 2. It’s returned 17 percent a year over the past three years. This just five years from its 37 percent drop in 2008.

One year does not make or break an investment plan. But, depending on your investment time frame, the risk you need to worry about differs from your neighbor’s. So, then, should your dosage of stocks and bonds/cash.

Where do you fall?

If your investment time horizon is less than 20 years – you expect to live less than that or you’re saving for college – then you should be concerned mostly with shallow risk. That means stashing more than half of your savings in bonds, CDs and cash, with some stock exposure commensurate with your ability to stomach the ups and downs.

This is a tough prospect, given the outlook for bonds in a rising inflation environment. Bernstein suggests you stay away from long-term bonds and invest a greater proportion of your safe money savings in CDs or money market funds than you did, say, six years ago.

Hold your nose and buy money markets, Treasury bills and CDs, Bernstein said.

If you have a 30-plus-year investment horizon – you're in your 20s or 30s -- you need mainly be worried about deep risk. In fact, Bernstein said, shallow risk is good, because that’s where there are prime opportunities to buy stocks when they are cheap and liable to increase dramatically in value.


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“If you have a high ratio of human capital to investment capital, then deep risk is the risk you should care about,” Bernstein said. “You actually want to seek out shallow risk. When you encounter that shallow risk, you can buy cheap.”

For those in between, with 20-30 years to stretch your investments, you are in the toughest spot. I’m talking near or recent retirees who rely on savings for some or most living expenses.

For you, Bernstein doesn’t offer much specific help. Other than tread carefully.

“The biggest problem, of course, is keeping your behavioral responses in check,” Bernstein writes. That is, resisting the urge to sell when shallow risk takes over.

For that, I say, you need a good adviser or a written investment plan and a level-headed friend to help you through the 2008-like stock swings ahead. Because they’ll happen. No risk betting on that.




-- Brent Hunsberger welcomes comments about his columns and blog. Reach him by e-mail or at 503-221-8359.


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