14 Apr Risk - Deep & Shallow Waters
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“A ship is always safe at the shore – but that is NOT what it is built for.”
― Albert Einstein
I think it’s fair to say that all investors know that, if they want to achieve higher returns than those available by keeping their money in a savings account, they need to be prepared to take some risk. Risk and reward are related and you cannot have one without the other.
That said, the finance industry has, in general, done a poor job of explaining risk as it relates to an investor, meaning that the average investor often confuses volatility with risk and can have a tendency to see both as interchangeable.
William Bernstein – a neurosurgeon-turned-adviser who specialises in the area of modern portfolio theory – wrote a great short booklet on risk[1], in which he explained the different risks that equity investors face, as follows:
‘Risk, then, comes 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.’
Shallow risk – precipitous equity market crashes that recover relatively quickly
The majority of investors who have invested in equity-based investments will have experienced this type of risk – those times when the stock market falls sharply and then takes months, or even several years, to return to its previous levels. The most recent example of this type of risk occurred during the credit crisis between 2007 and 2009.
Shallow risk is the one on which most investors focus, yet is perhaps the least relevant, particularly for those with long investment horizons. Although scary and emotionally fraught at the time, market falls do tend to be relatively short-lived and markets tend to recover fairly quickly.
Deep risk – a permanent loss of wealth
Bernstein defines deep risk as the permanent loss of purchasing power arising as a result of four types of events:
- Hyperinflation, such as was experienced in Germany during the Weimar Republic, where from 1921 to 1924 bonds and cash lost nearly all their value;
- Prolonged deflation causing a depression and high unemployment;
- Devastation, i.e. wars and geopolitical events, such as the Bolshevik revolution, which resulted in the closure of the Russian stock market and default on Tsarist government debt;
- Confiscation, i.e. when a government expropriates previously privately-owned assets – something which still happens today, e.g. the Argentinian government’s expropriation of the Spanish oil company Repsol’s assets in the country in 2012.
Whilst deep risk events are, thankfully, pretty rare, investors will often turn their own shallow risk events into deep risk events. This turns what was originally a temporary ‘paper’ loss caused by a sharp – but short term – downfall in the value of the investment into a permanent loss of capital as investors panic and sell the investment when that downfall occurs, thus crystallising the loss, then sit on the side-lines too fearful to commit cash to the markets again. The danger then is that the price of the investment recovers to the level at which the investor sold out (or even surpassing that level), with the investor still sat on the side-lines.
The second behaviour which can lead to deep risk is owning a concentrated stock portfolio, often referred to as lack of diversification; a study[2] in the US showed that 26,000 listed companies have been in and out of the US equity exchanges since 1926, with a mean life of only seven years. Only 36 companies have survived from 1936. Owning high exposures to stocks that fail is deep risk.
If only we had one of these….
Well, we can’t work miracles, I’m afraid. But there are a couple of simple strategies you can use to protect yourself against your own poor investment behaviour when you experience shallow risk:
- Understand the main drivers of investment behaviour
- Understand how risk and return work
- Understand the level of risk with which YOU feel comfortable, and how this can help you to construct an investment portfolio which works in all market conditions
The best way to avoid deep risk is actually really simple – own a globally diversified portfolio of several thousand stocks distributed predominantly across the developed equity markets of democratic countries with sound legal frameworks. Diversification really is the only free lunch.
Investors know that placing money in the bond and equity markets carries risk. Yet the way in which many people look at, and measure, risk is disconnected from both their actual longer-term investment horizons and their personal financial goals. They place too much focus on shallow risk, without understanding that how they react to what is an undoubtedly uncomfortable in the short term, yet generally relatively innocuous in the long term, event is what ultimately destroys wealth.
For a more in-depth look at a mature approach to managing wealth, download our Guide to Investing, here.
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.”
Peter Lynch, manager Fidelity Magellan Fund 1977 – 1990
Carolyn
[1] Bessembinder, Hendrik, Do stocks outperform Treasury Bills? (May 22, 2017). Available at SSRN: https://ssrn.com/abstract=2900447
[2] Bernstein, W.J., (2013), Deep risk: How history informs portfolio design. Available at www.amazon.co.uk
Originally published on 30/11/17