Deep Risk: How History Informs Portfolio Design

by William J. Bernstein

Deep risk: How History informs Portfolio Design is the third installment in the investing for adults series. this series is not for novices. This booklet takes portfolio design beyond the familiar “black box” mean-variance framework. Most importantly, the short-term volatility of financial assets, commonly measured as standard deviation, is a highly imperfect measure of the actual long-horizon perils faced by real-world investors subject to the vagaries of financial and military history. These risks have names—inflation, deflation, confiscation, and devastation—and any useful discussion of portfolio design of necessity incorporates their probabilities, consequences, and costs of mitigation. You’re an investment adult, so you know that the future efficient frontier lies well beyond our ken; presumably you already know all about the mechanics, long-term benefits, as well as the uncertainties, of wide diversification and factor tilt using low-cost, efficient vehicles and the risk/reward spectrum between all-fixed- income and all-equity portfolios. This booklet contains no magic formula for the “perfect portfolio,” but rather, with luck, a framework within which to think more clearly about risk.

Genres: Finance, Economics, Nonfiction, Business, History

57 pages, Kindle Edition

First published August 13, 2013

About the author

William J. Bernstein is an American financial theorist and neurologist. His research is in the field of modern portfolio theory and he has published books for individual investors who wish to manage their own equity portfolios. He lives in Portland, Oregon.

Reviews

[Ian Robertson · Rating 5 out of 5]

This is the third installment in Bernstein’s series of monographs for experienced investors. Looking back at a century of economic and financial data, Bernstein identifies four deep risks: inflation, deflation, confiscation, and devastation. These risks are different from the shorter term volatility of markets; they are the unlikely risks that traditional investors and ordinary folk will not recover from. In particular, he feels the Weimar Republic's hyperinflation is instructive - recall the images of German citizens hauling wheelbarrows of currency in order to buy bread - and the most relevant to today’s potential inflationary pressures. Bernstein dedicates most of his effort to this risk.

Triumph of the Optimists, an excellent but expensive book covering a hundred years of market data for 19 developed nations forms the basis of Mr. Bernstein’s inflationary worries. The sweet spot for stock valuations - a P/E of about 17 - is when inflation is between 0% and 4%. Bernstein wisely cites correlation rather than cause and effect, during years “with the highest inflation, stocks did badly, losing an average of 12%, but bonds did even worse, losing 23%.”

Looking at longer periods, though (multiple years of high inflation) the two major asset classes' returns couldn't be more different, with stock returns actually turning positive. “Although suffering from inflation in the short term, [stocks] protect against it in the long run.” “Put another way, stocks protect against deep risk, but exacerbate shallow risk.”

Stocks bring short term pain for long term gain, and the added bonus of a long term hedge against inflation. But as Bernstein points out in the first book in this series, Ages of the Investor, holding stocks is easier said than done. The 83% drop in the market during the Great Depression would have been a numbingly deep risk for those going through it at the time. But that's Bernstein's point, after all, that we've been through enough of this before that thoughtful investors can step back and use history to guide them in guarding against certain risks.

Deflation, a second risk identified by Bernstein, is a terrible deep risk as central banks and governments have few tools to combat it, but thankfully its only real manifestation has been the 20 plus years of stagnation in Japan. Counter to conventional wisdom, Bernstein states that "although gold bullion provided little protection against inflation, it did superbly with deflation." It seems that investors hoarding the precious yellow metal may be hedging a different risk than they think.

The third and fourth risks, confiscation and devastation, have happened many times in the past, though there is little investors can do about it other than owning assets and businesses in foreign jurisdictions. Americans’ restrictive tax reporting requirements on foreign bank accounts has acted as a sort of soft capital control, dissuading foreign banks from serving American clients, so in Bernstein's view real estate is likely the most practical hedge, though it requires ongoing upkeep. Bernstein notes that the US has confiscated assets in the past, for example in 1933 when citizens were required to turn in almost all gold holdings for $20.67 per ounce, and that today’s ultra low interest rates are a form of confiscation for net savers who own any fixed income (i.e. almost every retiree).

There are a few typographical errors, at least one of which is substantive. In addition to gold as a deflation hedge, Bernstein recommends "treasury bills and bonds," which for some may conjure images of short term instruments, but what he means, as becomes clearer in the following paragraph, is long dated bonds. While the monograph is well written and concise, the author loves to use his own acronyms as shorthand, which can send readers flipping to previous pages to remind themselves of the meaning.

After his excellent analysis, Bernstein concludes that while all should be aware of the deep risks, many of the potential mitigating actions are impractical to implement or require an extremely long time horizon. Food for thought, and though many will be unable to dine, it is worthwhile to peruse the Deep Risk menu.

[Ieuan Martin · Rating 4 out of 5]

Good. Puts some things into perspective.

[Tomek · Rating 5 out of 5]

How to insure against the four horsemen (inflation, deflation, confiscation, and devastation)? If you want to know you should read this book.
If you think about really long investment, then stocks is the best option. Stocks protect against deep risk, but exacerbate shallow risk. So, do not put money in stocks which you will need in the next 10-15 years.
Bonds and precious metals are also ok, but I do not know; I do not see any value in gold for example. You buy gold only for the purpose that you want to sell it to someone else in the future for higher price. But... it is worthless, you cannot eat it, it does not pay any dividends, it is just a shiny metal lol. It is much better for buy bonds for 1-5 years, and put the rest of your cash in stocks (not all of course).

[mark gerchikov · Rating 5 out of 5]

Concise, logical, helpful

An excellent little book which builds philosophical foundation behind methods of protecting your portfolio from major threats. Easy to read, hard to argue against. I am not changing my investment approach but better understanding of the risk translates into being more comfortable with the approach I have chosen

[Glenn M · Rating 1 out of 5]

Not only does Bernstein's Deep Risk not internally make sense, many of the concepts are misinterpreted from other authors and bent to make his unclear argument make "sense". This book fails in every possible way. Burning the paper would at least provide heat.

[Joseph · Rating 5 out of 5]

Great little book that could be helpful for lots of investors particularly during bear markets.

[Tony · Rating 5 out of 5]

An invaluable read for any one with financial investing aspirations.

[Haydn · Rating 4 out of 5]

Second time reading. Held up well.

[Steve Herreid · Rating 5 out of 5]

Awesome book on investment strategy. I need to re-read it every year.

[Mike Harris · Rating 4 out of 5]

Great history analysis of the correlation of economically destructive events and how different assets responded.

[Niklas · Rating 4 out of 5]

Short and useful

[Bob · Rating 4 out of 5]

Fantastic look at the what the difference is between short-term or shallow risk and long-term or deep risk of various types of investments and their causes (both economic and social). Most investors focus on shallow risk when making investment decisions, but should be more concerned with deep risk, especially when they are young and just beginning to save. Older savers, who are near retirement face the more difficult decision on how much to invest in shallow risk investments that tend to have a higher level of short-term risk, but have the ability to reduce the impact of the deep risk associated with inflation.

I highly recommend this book to anyone who has a significant amount of investment experience and has a good understanding of modern portfolio theory.

[Brad Felix · Rating 3 out of 5]

An interesting portfolio theory concept which addresses real risk, not measures of price variation (standard deviation) that have been the cornerstone of portfolio theory since the 1970s. The concept is simple - in the long-run your portfolio needs to protect you from four key risks: inflation, deflation, confiscation, and devastation. Given different probabilities of these events, you can position your portfolio appropriately with the correct weighting of specific asset classes. In the modern world, central banks have basically ruled out deflation. An international equity portfolio with a small combination of gold and mining equities is likely best allocation for a 30+ year time horizon.

[Chris · Rating 5 out of 5]

Some of the content appears in his other works - self-plagiarism is not one of this author's concerns. A good summary of what risk in investing really means especially from a long run historical perspective and in the light of other life risks. Leads to a more thoughtful asset allocation (though one with lower expected returns of course as one should be rewarded (and will be rewarded for intelligent risk) for risk in investing).

[Douglas Eu · Rating 4 out of 5]

Pro: a good discussion of "shallow risk" vs "deep risk"

Con: only saw risk in the sense of loss - or in other words only looking at the negative aspect - without considering the positive aspect best remembered in that famous golf expression "no risk, no reward".

[Niniane · Rating 4 out of 5]

Concise book that teaches how to evaluate portfolio risk in the face of inflation, deflation, taxes, war. Takes only a few hours to read. I found it instructive.

[Todd · Rating 4 out of 5]

Another in Bernstein's "investing for adults" series. Explains deep risk vs shallow risk. Good read especially if you are a DIY investor or have a large portfolio.

[Tom Plaskon · Rating 3 out of 5]

This small book illustrates the difference between shallow and deep risk and how this informs portfolio design for retail investors.

[Lubomir Christoff · Rating 5 out of 5]

Fundamental ! A historically informed framework for thinking about risk. Highly recommended for DIY investors.

[Nicolas Perrault · Rating 5 out of 5]

A refreshing overview of a kind of risk seldom discussed in investment books: risk over the extremely long term. If you worry about the chilling yet relatively unlikely prospects of hyperinflation, deflation, war, and communists seizing power, this book is for you. The reason I read it was that, as a Canadian living in a Canada with no nuclear weapons, I want to design my portfolio so that I don't lose everything if Americans invade.