Life After Full-time Work Blog

A distinction drawn by Dr William Bernstein

We know, pretty clearly, what we mean by risk: it’s the possibility of a bad outcome, of something going wrong.

Let’s be more precise and distinguish between two kinds of risk in the context of investments, the distinction being the time horizon under consideration.

We know that the chances are, for many of us, that we may not have enough money to match our retirement ambitions. In practice, a powerful mechanism (although far from the only one) to bridge the gap is to take investment risk, in the hope and expectation of creating a multiplier effect from investment returns.

Obviously the big risk is that, over the long term, returns won’t match expectations. The traditional way risk is expressed, in most investment situations, is via short-term volatility – which actually has very little impact on our long-term future.

This distinction (long term versus short term) is captured in a little gem of a book called Deep Risk, by Dr William Bernstein. (I love his entire series of brief books.)

He distinguishes between “shallow risk” and “deep risk.” Shallow risk is the risk that we’re forced to interact with the market at a bad time: we’re forced to buy right after the market has gone up, or to sell right after it’s gone down. Yes, it makes sense for volatility to be a good measure of shallow risk. Much of what’s called “modern portfolio theory” is based on this concept. But it’s an avoidable risk, at least partially, as I’ll show in a moment.

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Deep risk is much more serious. It’s the risk that the world’s economy, and therefore its collective stock market, doesn’t perform over the long term. This is what places us all in retirement jeopardy. And it’s unavoidable. There’s nothing we, as individuals, can do about it.

Bernstein identifies four possible causes. Fancifully, think of them as the four horsemen of the deep risk apocalypse: inflation, deflation, confiscation (taxation) and devastation (wars and natural disasters). How likely are they, and what can we do as a partial hedge against each of them? Read his 50-page book. Here’s my very quick summary.

• He sees inflation as the most likely, followed by confiscation, with deflation and devastation as the least likely – at least in America.
• He also sees inflation as having (relatively) the lowest cost of hedging against. His studies suggest that partial hedges against inflation are to invest in global equities, commodities producers and index-linked bonds.
• Against confiscation (direct taxation – and also indirect taxation on savers, like the post-2008 regime of financial repression), few would be willing to move abroad or renounce citizenship. In which case he thinks the sensible long-term partial hedge is to invest in foreign-held assets and real estate.
• A partial hedge against long-term deflation is more costly. He suggests global equities, long government bonds, Treasury bills (short-term assets) and gold.
• And against devastation: quite simply, foreign-held assets – against local devastation only, of course.

If you follow his thought process, you design an aggregate portfolio that offers you some chance of partially hedging against these forms of deep risk. And every investment in your portfolio will then have a specific job description: this will be your way to survive at least the worst effects of deep risk while giving you a hope and expectation of thriving if deep risk never occurs.

Bernstein himself points out[i], in a very practical way, that deflation is relatively uncommon and that your options for dealing with confiscation and devastation are very limited, so you should focus your attention on the deep risk of inflation, as it’s the most likely threat you’ll face, and it’s the one risk you can do the most about.

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How can you escape shallow risk?

In the accumulation phase, you don’t really need to. It has little effect because you’re investing regularly. Volatility just means that sometimes you’ll buy high and sometimes low. Commentators call this “dollar cost averaging” and have analyzed it thoroughly.

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One fundamental consequence of this distinction between deep risk and shallow risk is that we can have two (and only two) investment goals. One is to seek short-term safety (that is, to avoid shallow risk), and the other is to seek long-term growth (and therefore to be permanently and unavoidably subject to deep risk). Of course, the mixture of these two goals will vary from one person to another. At one extreme, some will be extremely risk averse and will want to avoid shallow risk entirely, even at the cost of reducing their periodic post-retirement drawdown significantly. At the other extreme, some (very few, I suspect) will be willing to focus entirely on long-term growth, at the cost of enduring potentially high short-term volatility in their periodic post-retirement drawdown.

There’s a further consequence, from combining this two-goal principle with Jan Tinbergen’s principle. Tinbergen (who shared the first ever Nobel Prize in Economics, in 1969) demonstrated that, if we have some number n of independent targets or goals, we need at least that number n of independent financial instruments. Here we’re thinking of two investments goals. And therefore we need (at least) two investment instruments. One focuses entirely on avoiding shallow risk; the other focuses entirely on seeking long-term growth. There’s no need to compromise either goal by combining them. In fact, avoiding shallow risk is actually an insurance procedure.

By the way, this is exactly the strategy followed by the world’s most sophisticated defined benefit pension funds. They divide their portfolio into two parts, typically called “liability-hedging” (what we’ve called avoiding shallow risk) and “return-seeking” (what we’ve called seeking long-term growth).

One side comment. After I published these thoughts in one[ii] of my Financial Times Money columns “The art of investment” I came across another – and a very insightful – way of distinguishing between the two forms of risk. Stuart Fowler (founder of the institutional investment management firm Fowler Drew) differentiates between “path risk” and “outcome risk,” which to me is an even more instinctive pair of terms than shallow risk and deep risk.

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I hope you enjoyed, and easily understood, those concepts.

That was, honestly, the easy part. The difficult part is trying to decide where one is at any moment: is the context shallow risk or deep risk?

If you think in terms of time frames, there’s no clear dividing line between the short term and the long term. My distinguished friend Malcolm Hamilton corresponded with me on related issues, and identified a number of intractable problems.

Let’s suppose we’re experiencing short-term volatility, and it’s on the down side, that is, returns are below what we expected, or below average, or whatever: it’s downside disappointment. Is this simply short-term volatility, or is it an indication of lower long-term average returns? How, when and by whom can you answer that question? Is the distinction fact or opinion?

Can a reduction in stock prices triggered by an increase in discount rates be distinguished from a reduction triggered by a decrease in expected growth rates? Again, how, when and by whom, and is the distinction fact or opinion?

Can an inconsequential short-term reduction in economic growth or corporate profitability be distinguished from the beginnings of a meaningful, extended decline in growth or profitability? How, when, and so on.

The point is that we know, in principle, that we can probably ignore much short-term volatility, while taking into account changes in long-term expectations and volatility; but the distinction can’t really be made in practice in the short term, which is where we live.

In other words, looking into the future is hugely uncertain. It’s typically only by looking backward that we can say, some time in the future, “Oh, that’s when it began to change.”

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A couple more angles.

One is, again, about the time horizons involved. As I said, there’s no clear dividing line. But I’ve re-read Bernstein’s Rational Expectations book and I find that he has a conceptual dividing line I hadn’t thought of. He refers to the stage of an investor’s life cycle, and thinks of the transition from shallow to deep risk as approximately the point where investment capital begins to exceed human capital (that is, your existing financial assets begin to exceed the present value of your future savings) – and for most people he suggests that this occurs a bit after the midpoint of the working career, around age 45 or 50. I must say, I had thought of the dividing line as being expressed more in absolute terms than in career-relative terms.

The other is a bit more detail on managing long-term risk. My friend Malcolm reminds me that one cannot, in practice, manage long-term risk in the long term. It must be managed in the short term. What we should do in the long term should depend on our anticipation of future events (inflation rates, interest rates, and so on); but we shouldn’t waste time deciding how those changes might influence our future investment posture. We should set today’s long-term asset allocation on the assumption that our current prospects don’t change, and then change it if and when prospects do change.

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Takeaway

There are conceptually two different forms of investment risk. One is volatility in the investment path; the other is a poor long-term outcome. The first is bearable if you design your plan appropriately; there is no way to overcome the second, and all you can do is reduce your spending. Worst of all, it’s usually impossible to distinguish between the two forms of risk, other than in retrospect.

[i] In his book Rational Expectations: Asset Allocations for Investing Adults

[ii] It was given the title “Pension savers – are you prepared for the risk?” on 30 January 2016.

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