(from Jason Zweig’s Wall Street Journal Money Beat blog dated 7/26/2013. Click here for the original post. Jason writes the Journal’s Intelligent Investor column every Saturday. He is also the best-selling author of Your Money and Your Brain. Follow Jason on Twitter @jasonzweigwsj.)
Earlier this week, the Dow Jones Industrial Average hit 15567.74, a new high. That was the 28th time this year the Dow closed at a record.
At these all-time-high prices, just how much riskier stocks are than alternatives like bonds, cash or gold depends largely on how you define “risk.” William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn., and the author of several books on investing and financial history, says risk takes two basic forms—and understanding the difference can help investors figure out what they should be afraid of.
What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price; decades ago, the great investment analyst Benjamin Graham referred to such an interim decline as “quotational loss.”
Shallow risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by sharp falls in price.
“Shallow” doesn’t mean that the losses can’t cut deep or last long—only that they aren’t permanent.
“Deep risk,” on the other hand, is an irretrievable real loss of capital, meaning that after inflation you won’t recover for decades—if ever.
In a forthcoming e-book, “Deep Risk: How History Informs Portfolio Design,” Mr. Bernstein sifts through decades of financial data and global history to identify what creates deep risk. The four causes he came up with sound almost like lyrics to the old Temptations song “Ball of Confusion,” but they are deadly serious: inflation, deflation, confiscation and devastation. “These forces can make assets lose most of their value and never recover,” he told me this week.
Imagine, suggests Mr. Bernstein, that you are a homeowner with a fixed annual insurance budget. If you live in a dry part of Kansas you probably should tilt your insurance spending toward tornado and fire coverage; if you live in Southern California you should cover earthquake and fire first; along a river, flood insurance matters most.
Likewise, you should insure against deep risks based both on how likely and on how severe they are.
Devastation—war or anarchy—is a long shot with horrific consequences, but there isn’t much you can do about it. If you hoard gold, you are as likely to be killed for it as to be protected by it. “For Armageddon, what you really need is an interstellar spacecraft,” Mr. Bernstein quips.
Confiscation—a surge in taxation, or a seizure by the government as happened to bank depositors in Cyprus—is more common. There, says Mr. Bernstein, your best option is to own real estate abroad, since governments rarely reach beyond their boundaries to seize assets of law-abiding citizens.
Deflation, the persistent drop in the value of assets, is extremely rare in modern history, Mr. Bernstein says. It has hit Japan but almost nowhere else in the past century, thanks to central banks that print money to drive up prices.
The best insurance against deflation is long-term government bonds. Diversifying your portfolio into international stocks also helps, since deflation often doesn’t hit all nations at once.
While bonds protect you from deflation, they expose you to inflation—far and away the likeliest source of deep risk. Mr. Bernstein notes that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years. That is deep risk at its deepest—a hole so profound most investors can’t get out of it in a lifetime. That happened in, among other places, France, Italy and Japan from 1940 through 1979, Mr. Bernstein says.
The best insurance against inflation, he says, is a globally diversified stock portfolio with an extra pinch of gold-mining and natural-resource companies. Treasury inflation-protected securities, U.S. bonds whose value rises with the cost of living, also can help.
But holding stocks to insure against deep risk drives your shallow risk through the roof. While stocks should protect you against inflation in the long run, they are guaranteed to expose you to frightening price drops in the shorter run. That, in turn, could push you into the final frontier of deep risk: your own behavior.
Most investors can’t survive the pain of plunging prices, Mr. Bernstein says, unless they have a surplus of both cash and courage.
If you have plenty of each, hang on. If you don’t, a sudden drop from record highs could lead you to bail out near the bottom, thereby inflicting a permanent loss of capital on yourself.
Look back, honestly, at what you did in 2008 and 2009 when your stock portfolio lost half its value. Then ask how likely you are to hang on in a similar collapse. Your own behavior can turn shallow risk into deep risk in a heartbeat.