Risks v Unknowns. Deep v. Shallow
Dear Clients and Colleagues,
The US and the world appears to be experience great tragedy and destruction. Hurricane Irma and Harvey are beyond comprehension and so I pray for safety, comfort, and recovery and do what I can to help.
Practically speaking, we can learn from what’s going on right now. Life is about living in an environment with both “risks” and “unknowns.” There are always things we can control for and always things we most certainly cannot. Some of these risks the people in the sourth are experiencing will not be recoverable, at least not in the near term.
Markets: Risks v. Unknowns
In regards to “markets” there are three live events going on right now that have risk and unknowns tied to them. There are reasons markets react differently than we expect.
Known risks are already priced into markets, unknown risks or even “the unknown” cannot be. When the unknown becomes known is when you see major moves in the market place in order to adjust to a brand new “known”.
Volatility is the result of markets learning new information not once understood or fully known. Knowing the directions of those changes in advance are difficult, if not impossible, to exploit.
Author and Investment advisor, Bill Bernstein, refers to “risks” as deep and shallow. Shallow risks are risks that theoretically time will cure. For example, a bear market or a stock market pull back or even events like the 2007-2009 Credit Crisis. Diversified investing over long periods of time, have recovered. This is why he refers to investing as “shallow.” This is why we say investing is a long-term decision, not a short one. If you have short-term needs, those funds should not be tied to long-term investments and vice versa.
Deep risks are risks that are generally not recoverable. Examples include war, devastation, Inflation, deflation, and confiscation.
We have three possible examples of both deep and shallow risks right in front of us today.
North Korea “War v. Rhetoric.” Rhetoric is of little consequence other than for those who are glued to anxiety inducing media influence. I recommend avoiding it.
War has history to it, and it is the winner that may “benefit”. I use that term “benefit” in the most skewed sense because war is never good; it is destructive and awful. Benefit here is relative.
All war is different and this type of possible war (nuclear exchange) is a complete unknown and so markets cannot possibly accurately price this exposure. Markets literally have now idea what to do with an actual nuclear exchange and so no matter how smart commentators may sound, they don’t know. That is what it means to be unknown. If a war of this magnitude actually happened, it would be devastating and unrecoverable to the people impacted beyond other long-lasting indirect impacts around the globe.
The markets currently are pricing in rhetoric, though. This is fortunate in that the markets generally are pretty smart to all known information. Let’s hope it stays that way.
Hurricane Harvey – this is a risk that occurred now and is mostly priced into “the markets.” Much of which will not be covered by insurance. This is a tragedy of life and environment, while it is also a serious loss of wealth. A deep, unrecoverable risk has been experienced for many.
The unknowns, though, remain. They include the fact that so many people did not have adequate insurance and the flood program combined with government funding will likely not be sufficient to return to par for many folks in Houston. This is a true destruction of wealth that cannot be replaced. Charity is one of the few sources of recovery for those impacted.
Hurricane Irma – This is also already a tragedy of life, environment, and property with more to come. This is a known risk combined with unknown. This is a deep and shallow risk as well. The pricing of risk is tied to insurance primarily. Insurance will most certainly take a deep hit on this if it hits South Florida. Markets can price this exposure. What they can’t price is the level of potential destruction beyond insurable property and to the loss of life, environment, and productivity. Again, Charity is one form of help.
Destruction of this magnitude is a combination of shallow and deep risks, with the deep very difficult to recover from. The extent of the destruction is also an unknown, impossible to fully price. We learn of it after the impact and for years to come. Markets price in that “learning” as it happens. Both hurricanes will remind us a lot about shallow and deep risks; both known and unknown.
We can’t prevent a hurricane or war, but we can be prepared for it both in body, mind and in our action plans.
We can also give to those who experience the “Deep” risks. Most people simply cannot fully recover from a “Deep” risk event. I strongly encourage charity at a time like this.
PS for further reading on “Risks”, below is my internal thinking around risks that I share with clients via Universal Memos. It includes expanding on Bernstein’s deep v. shallow risk definitions for your educational awareness. This is cut and pasted from the last Client Universal Memorandum Investment Philosophy update I sent out to clients earlier this year. Please let me know if you’d like me to send you another copy.
Risk has many definitions. Appreciating this gives us flexibility in managing risks.
Every investment comes with risk. In a world of inflation, volatility, and taxes, among many other “unknowns” there is absolutely no such thing as a risk-free investment!
When that risk occurs, though, is difficult, if not impossible to know. Risk, or uncertainty, is the nature of investing. One should not invest if they don’t want to accept this. Investing is a probabilistic discipline where you assess an investment’s potential upside and downside exposure and determine if that assessment matches your goals and own unique circumstances.
A client’s risk tolerance is a big factor in the process. Risk tolerance and risk management are unique to you and drives a lot of the portfolio design. Adherence is often directly related to clients’ ability to sleep well during tough times. I repeat this many times: build a plan you can stick to.
Risk tolerance also changes over time as well. The 2007-2009 Crisis is a perfect example of this. The lasting fear of investment losses from 2007-2009 crisis will continue to impact investor decisions over time.
The S&P 500 has experienced two bear market declines of extreme magnitude in the last 15 years of about 49% in 2000-2002 and 57% in 2007-2009. Prior to this, we have not seen more than a 48% decline since 1972-1974. One has to go all the way back to the Great Depression to find the occurrence of two “extreme magnitude” declines occurring within a 10-year span: the record-breaking 86% decline of 1929-1932 and the 55% decline of 1937-1938.
Subsequently it’s important to reflect on two things here:
Extreme downsides are very possible and real.
Extreme downsides are relatively rare which needs to be considered, but not dwelled upon because it could cause some investors to become too cautious at a long-term expense.
Managing risk tolerance does not always mean managing volatility, though. Risk has many definitions and different people will have different opinions on what risk means to them. For example:
Risk can mean opportunity for rewards.
Risk can mean uncertainty about outcomes and potential loss when the unfavorable occurs.
Risk can mean the negative impact that volatility can have on short-term portfolio needs.
Risk can mean the negative impact inflation has on keeping up with expenses over time.
Risk can mean running out of money before you run out of time.
Below are three ways to think of risk that impact financial planning over the long term. (Inspired by William Bernstein’s Investing for Adults Series and the writings of Howard Marks, Oaktree Capital):
Shallow risk. Shallow risk is the risk most people think about with investing. It’s the risk of loss of real capital that generally recovers after several years if you’re not forced to sell or react emotionally to market swings. Otherwise, shallow risk can become realized risk.
Deep risk. Deep risk is the permanent loss of capital. Broadly speaking, a typical diversified US investor has never experienced a complete, permanent loss of capital since most history of permanent loss occurred in places like German and Japanese bonds after World War II, or in places like Brazil’s inflation or Germany Confiscation. Examples of deep risk and the investments that “sacrifices return the least” during those times include:
Inflation. This is the most likely of all deep risks. It can be devastating to bonds. Stocks generally take a hit early on, but retain their real value in the longer term. A way that sacrifices return the least is a diversified global stock portfolio, Treasury Inflation Protected Bonds, and even precious metals and natural resource stocks.
Deflation. This is relatively rare. Deflation is devastating to stocks. A way that sacrifices return the least involves Treasury bonds, Income-oriented funds, and International Equities (if Deflation is US specific).
Confiscation. This refers to seizing assets and is very rare as well and has yet to happen in the United States. There are no known liquid, public investments that can be protected from seizure other than direct exposure to precious metals. “Taxes” can be considered a form of confiscation. Depending on who pays taxes and how much, it may make sense for investors to consider ways to legally defer tax payments. We consider taxes in client portfolios.
Devastation. This refers to such events as war, nuclear or environmental catastrophes, or natural disasters. There is very little one can do if a global disaster occurs or even if an unexpected regional disaster occurs.
Behavioral risk. Behavioral risk can mean one’s inability to be emotionally in check during times of crisis or chasing returns in times of prosperity.
Risk is fluid and counter-intuitive. Investors’ attitudes toward investment risk change frequently and usually they do the opposite of what would be considered logical. Investors get more aggressive when markets rise and more cautious as markets fall. They buy high and sell low. This is why investors often do so poorly with their portfolios.
Risk, at its riskiest, is when one either believes there is no risk or believes there is no hope.
Most of the risk in investing, then, seems to come from bad investor behavior, and less so from the companies, institutions, asset classes or securities involved, especially given that client portfolios are usually widely diversified and short of a catastrophic “Deep Risk” event, would not come close to a complete loss of value.
Behavioral risks can make both Shallow and Deep risk experiences realized or make them worse. Being a critical thinker and knowing how to build a long-term plan are important, but it is all a waste of time if your emotions get the better of you.
This is why we focus so much energy on potential downsides of a portfolio design. If you bail because you can’t handle the downside, it’s over, the portfolio realized the risk and recovery may be impossible. (Again…Stickiness matters!)
With all of these risk-concepts in mind, we return to a prudent approach to addressing risk:
Understand what risk means to you and define your own comfortable level of downside. There are two primary factors that impact risk tolerance: the financial capacity to accept risk within the investment program and the willingness to accept risk and return volatility.
Capacity to Accept is often determined by your outside resources, insurance coverage, net worth, time horizon, and lifestyle expenses.
Willingness to Accept is often determined by your psychological make up to “handle” or “want” a certain level of risk.
It is important to recognize the difficulty in achieving any objective in light of the uncertainties and complexities of contemporary investment markets, but try to train yourself to think of risk as both short-and long-term and the need to balance both.
Set aside funds in cash and short-term bonds for needs within the near future (however you define it, be it one, three, five years, or more). Those funds will not be subject to short-term volatility risk and have a low probability of being hurt by long-term inflation.
For those accumulating funds, you would fund a short-term reserve bucket and an emergency fund. For those in retirement, you would fund your lifestyle expense bucket and possibly an additional short-term reserve fund.
Your remaining funds can be earmarked for long-term needs such as accumulating assets for retirement, or replenishing your short-term reserve funds in retirement. Thus allowing your portfolio to ride out normal multi-year market cycles with hopes it has time to recover during bear markets.
Within that long-term portfolio, hold a diversified mix of investments that balance volatility with low volatility; risk aversion with risk tolerance; the fear of losing money with the fear of missing opportunities, and include a blend of assets that attempt to hedge shallow and deep risks within reason.
Risk tolerance can and will change. We should be prepared to adjust to those changes. I cannot know your definition of risk or risk tolerance without you telling me about it. Keep me informed if your risk tolerance has changed.
You can read more about Bernstein’s deep v. shallow risk thinking here: http://awealthofcommonsense.com/2014/04/william-bernstein-risk/