How deep should my risk level go?

Every investor knows that they need to take risks in order to achieve returns higher than cash.   If you asked ten investors if equities were riskier than cash, most would agree. But, of course, that depends on how one understands risk.

The investment industry has done a poor job of explaining risk as it relates to an investor. It tends to equate risk with return volatility.  William Bernstein – a neurosurgeon-turned-adviser and prolific investment writer – wrote a great, short booklet on risk, where he explained the different risks that equity investors face, as follows:

Shallow risk – a loss of real capital that recovers relatively quickly, say within several years

Deep risk – a permanent loss of real capital.

Shallow risk

Those precipitous equity market crashes that recover relatively quickly are examples of shallow risk.

This first level of risk is the one that most investors focus on, yet, perhaps, the least relevant (particularly for those with long investment horizons).

These are the scary and emotionally fraught times when equity markets fall dramatically, such as during these periods of instability that have hit the US market, since 1927.

Risk graph image.

Deep risk

Bernstein defines deep risk as the permanent loss of purchasing power, and lists four events as examples:

  1. Hyperinflation, such as that of the Weimar Republic, where from 1921 to 1924 bonds and cash lost nearly all their value
  2. Prolonged deflation causing a depression and high unemployment
  3. Devastation i.e. wars and geopolitical events, such as the Bolshevik Revolution resulting in the closure of the Russian stock market and default on Tsarist government debt
  4. Confiscation, which still happens today e.g. the Argentinian government’s expropriation of the Spanish oil company Repsol’s assets in the country in 2012

And he lists two investment behaviours that translate shallow risk into deep risk:

  1. Being shaken out of the market by a precipitous rapid fall (shallow risk) and then failing to get back in again – as there never seems to be a good time to do so – crystallises a real loss (deep risk)
  2. Owning concentrated stock portfolios creates the deep risk of high exposures to stocks that fail: the 26,000 listed companies that have been in and out of the US equity exchanges since 1926 have a mean life of only seven years and only 36 have made it through from 1936

The best mitigants of deep risk are to own a globally diversified portfolio of several thousand stocks distributed predominantly across developed equity markets of democratic countries with a sound legal-frameworks.

Equities provide the prospect of strong, long-term inflation-plus returns.

Investors know that placing money in the bond and equity markets carries risk.

Yet the way in which many look at, and measure, risk is disconnected from investors actual longer-term investment horizons: it focusses obsessively on shallow risk, rather than deep risk. 

Unless one understands the probability of an adverse event (hazard) happening and the effect of this exposure, due to a specific hazard on the individual investor, then it is likely that the real risks faced by an investor are masked by the shallow risks that have more emotional impact.

Owning more ‘low risk’ bonds (or cash) is not necessarily always the right answer when trying to avoid the deep risks that investors face.