Think you understand portfolio risk? Financial theorist William Bernstein may make you think again.

Investment advisors tend to consider investment risk in terms of standard deviations and correlations. Yet in Bernstein's dark view, deep risk is the permanent loss of capital - defined as a real (that is, inflation adjusted) negative return over a 30-year period. By that definition, even the Great Depression - during which markets recovered in a much shorter period of time - doesn't qualify.

Bernstein's deep risk concept is quite different from what he calls shallow risk, although that doesn't mean shallow risk can't be devastating in its own right, particularly if it occurs while clients are spending down their portfolios, potentially causing them to outlive their money.

When it comes to shallow risk, investors tend to be their own worst enemy. Both investors and advisors tend to overestimate risk tolerance, leading to an abandonment of investment discipline. Without that discipline, investors will sell when shallow risk causes stocks to lose about half their value - as has happened twice since 2000.

The solution to shallow risk is to understand the history of financial markets, Bernstein argues, and set an appropriate asset allocation that a client can live with for the long run.

The impact of shallow risk is easy to measure: It's the difference between geometric fund-weighted returns and investor dollar-weighted returns. That averages about 1.5 percentage points a year, according to Morningstar. This is caused by poor timing and performance chasing: Investors move into asset classes that have already performed well, then panic and sell when those assets plunge.



Deep risk, however, is something altogether different. After poring through historic data to determine the causes for a permanent loss of capital, Bernstein has identified what he terms the four horsemen of deep risk: inflation, deflation, confiscation and devastation. In his new book, Deep Risk: How History Informs Portfolio Design, he identifies strategies for handling each.

To fully understand deep risk - the possibility that, even after you've taken care of the personal sources of risk, the economic and political gods may permanently destroy part or all of your wealth - you again need to turn to financial history.

Consider inflation. Bernstein examines 16 nations that experienced annual inflation of greater than 7.5% over several decades, led by Brazil, Argentina, Peru and Israel. He concludes that, while inflation wasn't good for stocks, it wasn't devastating either. While stocks exacerbate shallow risk, he says, they actually protect against deep risk.

Bondholders, on the other hand, suffered huge real losses from hyperinflation: Their capital was repaid with currency that would buy far less. Over a period of decades, this erodes spending power - perhaps permanently.

Deflation is the next risk source. A deep look into ancient economic history can be alarming: For the half millennium after 1260, prices fell in 19 of the 50 decades, tumbling more than 10% in six of them, Bernstein writes. And during the 30-year period between 1866 and 1896, a period of repeated financial crises and social upheaval, the price index fell by an astonishing 41%. Even in the 20th century, the CPI fell by 29.8% between January 1926 and May 1933 - and U.S. stocks lost 83.4% of their real value between September 1929 and June 1932. They quickly recovered, however, and prolonged deflation didn't occur.

Bonds, especially long-term government bonds, performed well during periods of deflation. A globally diversified equity portfolio also insured against this deep risk.

Yet the occurrence of prolonged deflation has been much more rare since world currencies abandoned the gold standard, allowing a greater supply of money, Bernstein notes. He believes the probability of future deflation is an order of magnitude less than the probability of prolonged inflation.



Bernstein's other two elements of deep risk are geopolitical more than financial.

Confiscation, the third risk source, occurs throughout history. Governments do occasionally confiscate assets, with such events occurring as recently as five years ago in Argentina. Taxes may also be considered confiscation. Bernstein points out that during the 1980s, Congress imposed a 15% tax surcharge on retirement plan distributions of more than $150,000 - a penalty on those who had chosen to save rather than consume. (The tax was repealed in the 1990s.)

Even as our politicians act in inexplicable ways, the risk of outright confiscation in the U.S. is low, Bernstein says. Still, the way to insure against confiscation is to hold assets and real estate in foreign countries - such as gold in a Swiss safe-deposit box, or buying a townhouse in London.

Devastation is the last risk element. This might be more likely than you think; most developed nations have had some sort of devastation from military conquests during the 20th century alone. And it can work in concert with confiscation risk; if the U.S. government faced a catastrophe, it might plausibly respond by raising taxes.

One seemingly obvious way to insure against one nation's devastation is to own foreign assets, such as international mutual funds and ETFs owning foreign stocks and bonds. This may not work, however, if you're using U.S. securities to own those international assets; the government could simply confiscate those assets by taxing them. Owning foreign bank accounts has also become more onerous with new IRS regulations. You might be better off with real estate in foreign countries, because it would be more difficult for the U.S. government to confiscate those assets.

In his book, Bernstein doesn't list U.S. Treasuries as a safe asset to counter devastation - but in an interview, he agrees that, "In the event of a military or environmental catastrophe outside the U.S., U.S. Treasuries would most likely be considered a safe harbor and store of value."

Understanding the likelihood and consequences of deep risk are key to deciding how to protect clients. It's not so different from other types of risk management: Earthquake insurance, for example, might be critical if you live in California but may not be necessary for those who live in other parts of the country.

Bernstein offers a framework for analyzing and defending these risks, using four factors: probability, consequence severity, and both method and cost of insuring. That framework, which uses a three-point scale for three of the four factors, appears in the "Analyzing Risk" chart on the next page.



The risk source most worthy of attention is inflation, Bernstein says. He argues that owning a global stock portfolio, combined with some precious metals equities, is the best way to insure against this risk - which he sees as being the most probable of the four. These investments perform well in non-hyperinflationary environments as well, which is why the cost of insurance is low.

You can easily and cheaply protect against the severity of inflation risk if you can also manage clients' behavior in the face of shallow risks, he says.

Although Bernstein sees deflation as potentially more destructive than inflation, in terms of destroying real purchasing power, he also believes it is far less likely than in the past. Long-term government bonds offer great protection against deflation, as do stocks and gold - which, surprisingly, perform better in real terms in times of deflation than inflation. (Bernstein says the biggest surprise he found in his research was that gold didn't provide better protection against inflation.)

Unfortunately, such protection carries a price - because bonds can be very costly in the face of inflation, which is far more likely.

As for the other risk sources: While outright confiscation is low in developed countries, high taxation is far more likely, and the severity can be equally harsh, perhaps taking 20% to 50% of real assets. Insuring against this loss is relatively expensive and inconvenient, however, as owning gold and real estate in foreign countries takes some work.

And while devastation has dire consequences, the probability is low in most developed countries - and the means of insuring against it is the same as for confiscation.



What does this mean for client portfolio design? For those clients later in life with little or no earned income, Bernstein argues, shallow risk is what matters most.

If the clients have enough money to live on for the rest of their lives, the majority of their portfolio should be in TIPS, to protect them against both shallow risk and inflation.

While fixed-rate bonds would do better with deflation, Bernstein feels future deflation is unlikely. And even under deflation, he notes, a client's real portfolio doesn't decline and the client benefits from lower taxes. "If you've already won the game, quit playing," he says.

It's a different story for younger clients. Shallow risk is a good thing if they can stay the course; the advisor can rebalance when stocks plunge. If their stock portfolios have a value tilt, then they should perform better with inflation, since value stocks are more highly leveraged and will be paying off their debts with cheaper real currency.

He also suggests a geographically diversified equity portfolio, with 30% to 40% in international stocks. Overweighting precious metals and mining stocks as well as energy has also provided some protection against inflation, historically. Some fixed income is still needed, however, if only to allow for rebalancing.

The trickier case is for clients who have a significant portfolio but haven't completely met their financial goals. For these clients, Bernstein recommends a more balanced portfolio, with high-quality bonds, such as TIPS, and the equity allocation discussed above, making sure the client can rebalance when shallow risk occurs.

As for confiscation and devastation risks, however, there's not much a client can do, Bernstein concedes - "beyond [having] an interstellar spacecraft." He does suggest owning a few gold coins, however, and giving a bit more consideration to foreign real estate. "If the client was already considering buying a flat in London," he says, "the potential for confiscation and devastation could be additional reasons to pull the trigger."



Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS and is an adjunct faculty member at the University of Denver.

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