Deep Risk by William Bernstein

[MichaelB]

Just finished reading William Bernstein’s new booklet, “Deep Risk: How History Informs Portfolio Design” This is part of his (aptly named) series “Investing for Adults” Investing for Adults. This new booklet (only 51 pages) was first highlighted by Jason Zweig a few weeks ago in the WSJ blog http://blogs.wsj.com/moneybeat/2013/07/26/shallow-risk-and-deep-risk-are-no-walk-in-the-woods/ , who gives a very good summary.

It is an excellent high level discussion of financial risk, which he categorizes in a way that makes sense to non-financial professionals and would easily fit into many forum discussions. After describing the primary causes of financial loss he presents his view of the likelihood, impact, recoverability and recommended investing strategy for each. He sees inflation as particularly dangerous and fixed income as deeply exposed, recommending a “globally value-tilted diversified portfolio, perhaps spiced up with a small amount of precious metals equity and natural resource producers” as the safest investment over time.

The ebook price is $5, and Amazon Prime members can borrow it.

 

[haha]

Just finished reading William Bernstein’s new booklet, “Deep Risk: How History Informs Portfolio Design” This is part of his (aptly named) series “Investing for Adults” Investing for Adults. This new booklet (only 51 pages) was first highlighted by Jason Zweig a few weeks ago in the WSJ blog http://blogs.wsj.com/moneybeat/2013/07/26/shallow-risk-and-deep-risk-are-no-walk-in-the-woods/ , who gives a very good summary.

It is an excellent high level discussion of financial risk, which he categorizes in a way that makes sense to non-financial professionals and would easily fit into many forum discussions. After describing the primary causes of financial loss he presents his view of the likelihood, impact, recoverability and recommended investing strategy for each. He sees inflation as particularly dangerous and fixed income as deeply exposed, recommending a “globally value-tilted diversified portfolio, perhaps spiced up with a small amount of precious metals equity and natural resource producers” as the safest investment over time.

The ebook price is $5, and Amazon Prime members can borrow it.

Thanks for posting this. The Jason Zweig article is excellent. Many people seem to not understand or at least not honor this distinction between what he is calling shallow risks and deep risks, identical to what many of us who think about such things think of as volatility vs. risk of important, permanent loss. Academics seem to mostly use variability as their all purpose definition of risk, so modern academically influenced portfolio management is strongly tilted toward this.

But successful portfolio managers have always made this distinction, and have written about it for over 50 years

Many private investors/savers confuse their feelings with reality. However, if you have been at this with your eyes open long enough, you realize that eventually feelings and reality likely will be reconciled, by feelings abruptly adjusting to reality, often not a pleasant experience.

It is very difficult, because the last thing reality cares about is whether you are "comfortable" with your AA, however if you are not comfortable or cannot educate yourself to become comfortable, it is awfully easy to crap out during a temporarily distressing market period, or of special relevance to bootstrappers, when your resources are really not quite adequate to the new reality.

I do think that attempting very long, self supported absence from paid employment or active business is essentially a heroic undertaking, that most of us might avoid if we really understood the risks. Too late now! Banzaii!

Ha

 

[Meadbh]

Thanks for the link, MichaelB. Being the cheapskate that I am, as well as a data nerd, I have downloaded the report from Credit Suisse referenced in Zweig's blog for later reading.

obgyn65, we know you're busy, but if you read anything on the forum this month, please read this thread and the links.

 

[aim-high]

I do think that attempting very long, self supported absence from paid employment or active business is essentially a heroic undertaking, that most of us might avoid if we really understood the risks. Too late now! Banzaii!

Ha

Love it!

 

[donheff]

Interesting piece by Zweig. I am always reassured when I read someone cautioning us to look at how we responded to the crisis in 2008/2009 and evaluate how we would react to a another whack like that. If we went through a similar drop and recovery I would weather it just. But what about a truly black swan that drops us into a bottomless hole? Oh well, what are the odds?

 

[Spanky]

He sees inflation as particularly dangerous and fixed income as deeply exposed, recommending a “globally value-tilted diversified portfolio, perhaps spiced up with a small amount of precious metals equity and natural resource producers” as the safest investment over time.

Precious metals or gold equity funds have been very volatile. For example, Vanguard's precious metal fund has a YTD of -33.82% and a 5-year average return of -13.43%. However, some experts say that these kinds of funds actually reduce overall portfolio volatility and provide stability over time.

 

[Elbata]

I've always been interested in world history. While I may have been able to tell you some facts, how society evolved never became clear to me till I read Bernstein's "Birth of Plenty". I'm on third reading, I love that book.

 

[dtbach]

I figure the guys at Fidelity and Vanguard will read and understand this stuff. That way I don't have to.

 

[brewer12345]

We should all be able to accept and understand that there are some risks you simply cannot hedge, at least with a portfolio. The world is a fat-tailed place and you pays your money and you takes your chance.

 

[REWahoo]

We should all be able to accept and understand that there are some risks you simply cannot hedge, at least with a portfolio. The world is a fat-tailed place and you pays your money and you takes your chance.

+1

Better watch your ass-teroid!

 

[NanoSour]

Precious metals or gold equity funds have been very volatile. For example, Vanguard's precious metal fund has a YTD of -33.82% and a 5-year average return of -13.43%. However, some experts say that these kinds of funds actually reduce overall portfolio volatility and provide stability over time.

Yes VGPMX has taken a beating this year. Bought in Feb

 

[dtbach]

We should all be able to accept and understand that there are some risks you simply cannot hedge, at least with a portfolio. The world is a fat-tailed place and you pays your money and you takes your chance.

Like trying to hedge your portfolio in Poland 1939.

 

[Fishingmn]

Makes me glad that I have put 1/3 of my portfolio into rental real estate over the past 4 years. While every investment has risks, I do like that it is one of the best asset classes to hedge against inflation since home prices and rents generally follow inflation.

 

[Meadbh]

Makes me glad that I have put 1/3 of my portfolio into rental real estate over the past 4 years. While every investment has risks, I do like that it is one of the best asset classes to hedge against inflation since home prices and rents generally follow inflation.

+1, except that my allocation to rental real estate is considerably less than that. The regular cash flows from real investments helped me to stay the course in 2008-9. I also have some precious metals. It's reassuring to hear some confirmation that one's risk mitigation strategy makes sense.

 

[imoldernu]

Bits and pieces of long term risk that poke their way through the fog...

FRB: H.8 Release--Assets and Liabilities of Commercial Banks in the United States--August 30, 2013

Line 44 (memoranda) for larger banks is showing increasingly large losses in 2013... in the available for sale assets. This may be a reflection of the attempt to comply with the push for more stringent stress tests.

In 2009, a major part of the bank rescue was an easing of the mark to market values requirements of the securities representing the housing bubble. With the incremental increase in Fed Rates, many larger banks are offsetting their income increases by taking some of the losses now in an attempt to get ahead of more stringent reviews of actual values.

Goes to the point of long term slide versus sudden shocks. Watching the AFS numbers since the 2009 crisis, may be a, if not the major reason for the banks' (recovery).

At the same time, another change is in the works in an attempt to stabilize other worries stemming from the 2007 - 2009 problems. Regulators ease derivatives rule to avoid harming economy | Reuters
Rehypothecation of derivatives (looser collateral requirements) to allow a greater safety cushion .... puportedly an extension for as much as 2 years, to ease the stress from the planned tightening of margin requirements.

To me, the question of deep risk goes beyond historical ups and downs, and global balance. Stretching financial theory to accomodate new and unprecedented instruments, and shrinking world economy differences seems to be fitting the problems into older solutions.

The 1634 Tulip Bubble happened, but despite the simplistic analogies, in no way a precursor of the problems of 1893, 1920, 1929 or 1937. The devil is in the details, and the details are really complex. The above two links are just a tiny part of the complex.

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.

Donald Rumsfeld

scary stuff

 

[FIREd]

It's reassuring to hear some confirmation that one's risk mitigation strategy makes sense.

+1. I found the Jason Zweig's blog post quite re-assuring as I'm already doing a lot to hedge against those so-called deep risks. Of course if the zombie apocalypse comes, I'll be toast. But I'm not going to spend much time worrying about that kind of devastation.

 

[siamond]

Just read the booklet last night, following your advice (thank you!). This is actually a reasonably easy read, I would advise to read the real thing, not just the blog summary of what is already a fairly short write-up.

Sure, if we followed past advice from the author (I did!), we're already hedging against most of those deep risks, but it's good to develop a better understanding of WHY that is (being fully convinced should go a long way in staying the course).

It is also eye-popping to see how special the US are (and have been) for the investor in terms of minimizing deep risks. On one hand, we should be really grateful to be here, on the other hand, it shows how things can really unravel way beyond our usual backtesting analysis (e.g. ala Firecalc)...

Something Dr Bernstein didn't discuss though is a major collapse of the technology behind the stock market exchanges. This one makes me quite itchy, and is of course especially relevant in the US. When I see the crazy complicated technology being used, and the excesses of the computer-driven sub-millisecond decision-making algorithms, I cringe big time, it wouldn't take much for it to go completely haywire. This has the potential of a MAJOR crisis impacting each and every of us. Barring keeping some gold bars at home (ok, maybe not), I am not sure how to hedge against this one though!

 

[dtbach]

Something Dr Bernstein didn't discuss though is a major collapse of the technology behind the stock market exchanges. This one makes me quite itchy, and is of course especially relevant in the US. When I see the crazy complicated technology being used, and the excesses of the computer-driven sub-millisecond decision-making algorithms, I cringe big time, it wouldn't take much for it to go completely haywire. This has the potential of a MAJOR crisis impacting each and every of us. Barring keeping some gold bars at home (ok, maybe not), I am not sure how to hedge against this one though![/QUOTE]

Keep some good backups. Paper copies would be good too.

 

[Gatordoc50]

If you believe that a function of the capital markets is to provide returns for investors that meet or exceed inflation, then buy and hold is a sound strategy. Unfortunately, that function has never been declared or promised.

 

[Running_Man]

I am going to download the booklet and read it before commenting further, but is there an actual portfolio that Bernstein is advocating or is it more of his usual describing here are the investments that can lower this risk in various scenarios when held for the long term and you can pick and choose what you like?

 

[gerntz]

Just finished reading William Bernstein’s new booklet, “Deep Risk: How History Informs Portfolio Design” This is part of his (aptly named) series “Investing for Adults” Investing for Adults. This new booklet (only 51 pages) was first highlighted by Jason Zweig a few weeks ago in the WSJ blog http://blogs.wsj.com/moneybeat/2013/07/26/shallow-risk-and-deep-risk-are-no-walk-in-the-woods/ , who gives a very good summary.

It is an excellent high level discussion of financial risk, which he categorizes in a way that makes sense to non-financial professionals and would easily fit into many forum discussions. After describing the primary causes of financial loss he presents his view of the likelihood, impact, recoverability and recommended investing strategy for each. He sees inflation as particularly dangerous and fixed income as deeply exposed, recommending a “globally value-tilted diversified portfolio, perhaps spiced up with a small amount of precious metals equity and natural resource producers” as the safest investment over time.

The ebook price is $5, and Amazon Prime members can borrow it.

His "The Intelligent Asset Allocator" has been my investment bible for 15 years.

As for, "He sees inflation as particularly dangerous and fixed income as deeply exposed, recommending a “globally value-tilted diversified portfolio, perhaps spiced up with a small amount of precious metals equity and natural resource producers” as the safest investment over time.", my passive investing advisor has kept bond fund durations low, is firmly in the global & value camp, and spices me with GLD & gas transmission MLP's. Maybe he reads Bernstein?

 

[haha]

I finished this short book, and will go through it again before I pass it back to Amazon. A few things jump out- this advice is not just more of the same asset 60:40 or 50:50 stock:bond asset allocation, and save 25X spending before retirement. This is a lot more demanding. He says that if you are not working, you should have 15-20 x your (expenses-(SS and pensions)) in liquid and ultra safe investments like T-bills and short term liquid notes and CDs. Now remember that these investments are designed to guard against shallow risks, which are relatively short term, but will leave one heavily exposed to deep risks which tend to be longer term, but may actually come suddenly. He more of less suggests that retired people must design to deal with shallow risks, no matter what other risks may be left unguarded.

It seems that if this book is taken to heart, and if a secure retirement is something you want, run, don't walk to get a government job if you can. Otherwise save enough for your chosen SWR, but also save another 15 -20 x(expenses not covered by COLA annuities). So non-govt workers had better have very good jobs, or no life, or both, while they try to put together this huge amount of retirement funds.

And remember, your taxes will have to answer to very powerful public unions, and very active and empowered "poor people" who might prefer that you do their retirement planning and saving for them. (Hey, it's only fair!) Millionaires paying close to 0 FIT will likely not be a long term condition, no matter how clever their tax planning

Ha

 

[Running_Man]

Yes an unusual take on retirement'
"Shallow risk requires deep liquidity", is one of the first statements made, as is a discussion of the Harry Browne Permanent Portfolio, after which the book begins to take a non- academic look and becomes political in my mind, calling gold investments "creepy". Indeed even as he mocks the Permanent Portfolio over and over again and attempts to improve it by the tried and true method of adjusting for substitutes, he appears to realize that Harry Brown's Permanent Portfolio actually did what he said it would, but then I guess because it lost money in 1975 it is not actually of value.

In arguing for stocks, he makes the classic mistake of stating that if one had stayed in stocks throughout WWII in Germany by the 1950's you would have been ahead of the game. The truth is if you stayed in Germany and had wealth prior to WWII, you most likely were dead or destitute by the end of that war. If you owned stocks, the government had a record of your investments and would confiscate them when you tried to leave Germany during WWII. The important point to realize is if you have a crazy leader in your country and they are railing against the class of people you belong to, LEAVE!!.

If one held gold in trust oversees, one could have escaped this madness. When Germany invaded Poland 3.3 million Jews lived in Poland, many tried to escape but did not have the financial wherewithal. By the end of WWII 300 thousand were alive.

Bernstein's faith in common stock asset allocation and enough "liquid assets" misses Harry Browne's entire take on this, even though he ends his book in somewhat of an endorsement of Craig Rowland's permanent portfolio.

The discussion of asset allocation during the 1929- 1932 was also laughable to me as he says the discussion was purely theoretical and there was no way to do it at the time, which by default makes the discussion a non-starter. Indeed his discussion of what Benjamin Graham stated in Forbes in 1932 is so true that Bernstein appears unable to grasp the statement in a meaningful way to today's investing, "Those with enterprise do not have money, those with money do not have the enterprise".

To provide a solution to problems of the past, that were not available, and to basically use them as a means for back tested partial portfolio advice, without sticking a firm stake in the ground allows Bernstein in the future to claim to be correct no matter what happens. No one in 35 years will be able to write a book and compare in detail their method to Bernstein's as he did throughout this book with the permanent portfolio. I find this cherry picking of the highest order and the idea of having 20times assets in liquid funds equivalent to Steve Martin's advice on how to become a millioniare, "First get a million dollars....".

 

[siamond]

I did a second pass on the booklet, reflecting on the statements that struck me the most, this all seems very sensible (as expected from Dr Bernstein), but... there is one part I don't quite get. Why does the author keep suggesting some precious metals (e.g. gold) in the portfolio?

For both inflation and deflation deep risks, he's suggesting multiple other mechanisms (e.g. international diversification, a good deal of stock, etc) which seem much more effective, as well as beneficial for improving returns (you know, things do go well sometimes! ).

As to confiscation/devastation, clearly PMEs in your portfolio won't help.

Personally, if precious metals would find a small place in my portfolio, it would be to play the rebalancing game and also to have some money to spend in those times when the market tanks all over the place, stock & bonds alike, and people panic going to gold, hence PME is the only asset going up. But that's shallow risk, not deep risk...

I must have missed something. Views?

 

[daylatedollarshort]

For what is it worth, here is a list of the top 10 assets owned by millionaire households ($2M+) in the U.S. based on estate tax data, 2007 - 2009. Publicly traded stocks are 12.9%:

The Top Ten Assets Owned by Millionaires