When it comes to our personal financial affairs, there are two major areas of risk that we need to understand and combat. One is behavioral and one is economic/political.
For some strange reason though, investors and advisors focus a lot of conversations on risk by discussing volatility. This is nonsense of course. Volatility is a measurement of expectation, not risk. Here is Mr. Buffett on the subject:
…volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
Some numbers from 1928-2016 might help explain exactly what volatility (aka standard deviation) tells us:
It is important to know that stocks are more “volatile” than bonds (i.e. they go up and down by a larger amount on average), but that volatility in itself is not what makes stocks risky. It is us as investors, and more specifically our emotions, that introduce the risk of selling during volatile times (In most cases at a loss) into this equation. We are the risk, not volatility.
Funny enough, it is actually the case that for us long-term investors, stocks have been the less risky investment over the last 100 years compared to cash or bonds. Here is our pal Mr. Buffett again:
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.
We know that from 1928-2016, after inflation, stocks have returned 6.38%, while bonds have only returned 1.77%. Reaching financial goals would be close to impossible with an annual return of 1.77% per year. Mr. Buffett knows this…you should too.
Now, with “volatility as a good measure of risk” out of the way, lets explore a more appropriate definition of risk for us long-term investors. I will give Mr. Buffett a break and introduce Dr. Bernstein as our next guest.
Dr. Bernstein has written many books, all of which I recommend, but the one we will focus on today is titled “Deep Risk: How History Informs Portfolio Design”. This book helps explain the concepts of shallow risk versus deep risk. To me, this is the best definition of risk that I have come across so far and it does a much better job of explaining what real risks we investors may have to deal with.
(Note: I will be paraphrasing from the book in this next section. Any comments in bold or italics are emphasis mine)
Shallow risk is a temporary drop in an asset’s market price. Shallow risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by sharp falls in price.
Even safe government bonds have had declines of double-digits throughout history.
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.
These deep risks include: Devastation, Confiscation, Deflation, Inflation and Poor Behavior
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.
If you really are concerned by this, stockpile food, water, guns and ammunition.
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.
First, do not think this is out of line for us here in America. You only have to go as far back as the 1970s to see top tax rates in the 80%-90% range. Much like devastation though, there is very little most of us can do about confiscation. Direct international real-estate investing is a bit of a stretch, even for successful self-employed professionals.
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.
These are the two areas that are the most likely to affect us when planning our financial futures. Inflation is one of the components that is widely discussed when we think about “running out of money”. To combat these two challenges, the solution is simple: Gain a healthy dose of exposure to stocks in the U.S. and abroad, and then mix in a smaller amount of long-term government bonds with treasury inflation-protected bonds as well. Easy. Wait, actually, maybe not…
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.
You knew it would come back to this. It always does. We are the enemy.
The reason Warren Buffett is such a great investor is two-fold. He does have great analytical and fundamental viewpoints on companies, but more importantly, he is a stone-cold killer when it comes to his investment behavior. He has had multiple draw-downs of over 50% and just continues to invest more and more over time. Clearly he has advantages that most of us don’t, such as not having to worry about funding his financial goals. The bottom line is that for nearly all of us, holding 100% stocks is out of the question because of our behavioral tendencies, but the lesson is still very important.
Regardless of where your allocation ends up after figuring out your risk tolerance, the most important thing when it comes to your investments is your behavior. Everything else pales in comparison to this, even your portfolio’s performance.
Have some fun out there!