William Bernstein on Deep Risk, Shallow Risk, and Investing for the Long-Term

riskWhat are the many kinds of investment risks? Most people think of the risk of losing their money. William Bernstein dissects this simple view into many different shades of risk and astutely discusses that not all risks are of equal possibility. So while some may worry about a certain risk, they should also consider how possible that event to create the risk may be. Yes, markets go up and down all the time. But, that is not risk! The risk comes from how you react to markets.

Professor Wade Pfau made an interesting short video about the difference between Shallow Risk and Deep Risk (discussed more below).

But first, this risk difference comes from a 3-part series of booklets by William Bernstein. I will offer short observations in bullet form here and encourage the advanced readers to look at the booklet(s) that may interest them further.

The first booklet, “The Ages of the Investor,” looks at the sequence of market returns.
– There are two different kinds of risk: 1) Savings Sequence Risk
– The sequence of returns does matter when investing periodically and does NOT matter with lump sums when invested. “That is, with a lump sum, a particularly good or bad sequence of returns will not affect your final result one bit.”
– Younger savers want volatility to get more exposure to buy low opportunities.
– Second kind of savings risk: 2) Very Low Equity Returns
– Mitigated by periodic investing
-Thus … challenge is to recognize (prediction isn’t possible) when situation changes from the first (normal) to the second kind (bad state of the world)
– Fear of the second kind of risk tends to make annuities popular for retirees. However, these come with “four large disadvantages: 1) Do not allow for emergency withdrawals, 2) have to give up ownership, 3) profit needs reduces payouts; profit needs help avoid, don’t prevent 4) insurance companies may not survive the very same systemic crisis that leads to annuity popularity (and state guarantee funds may be inadequate in the same situation as well due to low returns).
– Liability Matching Portfolio is a form of Safety First School of Thought.

The second booklet, “Skating Where the Puck Was,” looks at correlations.
– In a perfect world, investment options would be totally uncorrelated to each other. At one time in history, this was truer than it is today. With communications shrinking the world, events on one side of the globe quickly reverberate through the markets to the other side. The effect is to increase correlation.
– The effect is that strategies that used to work tend not to anymore due to correlations. And new strategies quickly fall on their faces when events turn their ugly head and bite.
– Bernstein ticks off many strategies falling on their faces due to the effect of strategies becoming more widely used.
– My main beef with the tone of this booklet is the focus on beating markets (which may be more to say what the strategies are about, then what his other written works describe – indexing). The goal should be first about how to reach YOUR goal … and then design the portfolio and your other financial resources (i.e., Social Security, pension if you have one) according to that plan. Otherwise, the risk is investing without a plan which more often than not leads to chasing markets and emotions.

His third booklet, “Deep Risk,” circles back to Pfau’s video and blog about this booklet.
– Risk = [size of the loss] X [duration of the loss]
– Shallow Risk = loss of real capital that recovers relatively quickly
– Deep Risk = permanent loss of real capital
– A person may experience shallow risk, but put themselves into deep risk by buying high and selling low … thus, permanently losing the capital value they would have had if they had stuck it out (goes to the two kinds of risk in the first booklet).
– You can NOT avoid deep risk no matter how disciplined or prudent you are (think 2008).
– Gold is NOT an inflation hedge … he explains it works during DEflation (falling general price levels). [ Two other risks he discusses are confiscation and devastation].
– Not all 4 of these risks are equally possible … he discusses probability and how this may impact allocation to address those that concern you. (here is a great article by Allan S Roth ” ‘Deep’ Portfolio Risk: How to Protect Clients Portfolios” that discusses the concept of Deep Risk and Shallow Risk).

Moral of the story of the 3 booklets:
– Establish an allocation you can stomach through good and bad times.
– Stick with that well thought out allocation through good and bad times.
– Be patient through good and bad times.
– Recognize the difference between Shallow Risk (most of the market declines) and Deep Risk (systemic changes happening).


PS. Please note the comment below that I added 24 Aug about the 4th book in this series.


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4 Responses to William Bernstein on Deep Risk, Shallow Risk, and Investing for the Long-Term

  1. Larry Frank, Sr. August 24, 2014 at 8:08 am #

    Bernstein’s 4th in this series is “Rational Expectations” http://www.amazon.com/Rational-Expectations-Allocation-Investing-Adults/dp/0988780321/ref=sr_1_1?s=books&ie=UTF8&qid=1408892234&sr=1-1&keywords=rational+expectations

    Popular among those who try to predict is a relationship between Shiller’s CAPE and forward long-term returns (short term is still unpredictable … and this relationship continues to be studied), Bernstein observes a key point: “Can you make money off of this? Probably not. The reason why is that valuation metrics are not ‘stationary.’ ”

    In other words, there’s an illusion of predictability looking back at how data correlates, but the future always shakes things around where new patterns emerge, but only recognizable after the fact … he illustrates how the patterns change on pages 92 & 93.

    Finally, an example of Deep Risk (booklet 3) is how we are not able to escape the effects of demographics which will force people who haven’t saved to work longer. Nobody can extract themselves from demographic realities and that effect on the economy (chapter 4).

  2. Larry Frank, Sr. February 4, 2015 at 7:57 am #

    What are the concepts to incorporate portfolio construction with all of the above points Bernstein raises? See this post … “Black Swan Portfolio Construction – is it possible?” https://blog.betterfinancialeducation.com/behavior-corner/black-swan-portfolio-construction-is-it-possible/

  3. Larry Frank, Sr. May 1, 2021 at 10:19 am #

    Black Swan concepts may come to mind here too … What to do?


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