Bernstein’s Deep Risk: How History Informs Portfolio Design

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During their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed lessons learned from William Bernstein’s Book – Deep Risk: How History Informs Portfolio Design. Here’s an excerpt from the episode:

Jake: All right. This week, I’m going to be talking about this neat little book by William Bernstein, and it’s called Deep Risk. And it’s nice because it’s just a little 50-pager that you can get through pretty easily, but what I like about it is that it moves beyond the mean variance framework of Markowitz, that has kind of come to define what risk is. And instead, it uses history and almost turns it into an insurance problem. And so, what is the probability and the impact and the cost to insure against, and those are all important things to understand.

I guess the first thing that’s interesting about it is that, he says that that loss has two dimensions. You have the magnitude and the duration. There’s an integral, like an area under the curve of loss. Let’s say you were down 50%, but it was only for a year, and let’s say it came back all of a sudden quickly, that would not count as much as say being down for a much longer period of time and then flat. There’s a duration to it as well.

Then, he sort of breaks it up into what he calls shallow risk and then deep risk. And the shallow risk is more what I think most people would consider risk. They think about like, “My portfolio is down.” Okay. Well, he says that over a short term, and then his short term is like 7 to 10 years by the way, so already we’re like talking way different than most people. But short-term risk like that would be a typical market correction, a bear market. But that’s short term and shallow in nature, and that eventually it tends to come back and then you make new highs. If you can get through that, the behavioral gap there, that’s not actually a real risk to your portfolio.

The real deep risk comes from– he has four different things. He has a sustained hyperinflation, a sustained deflation, confiscation in taxes, and then devastation, so like war and things like that. And those are the real actual deep risk to a permanent impairment of your portfolio.

Tobias: You can protect against that?

Bill: No.

Jake: Yeah.

Tobias: That’s like a Russian stock market, getting ended in 1900 or whatever it was.

Jake: We’ll go through it.

Bill: No, I would say my visceral reaction is you can protect against devastation because that would be a big bet on the wrong company or something like that. But a lot of that stuff, you just sort of living in. I guess asset diversification could protect you, but I will let you go on and we’ll see where you end up.

Jake: There’s your answer here. Just hang in there.

Tobias: Bitcoin.

Bill: [crosstalk] Yeah, that’s right.

Jake: One of the things that’s interesting is that the– I think that a lot of people are blind right now to the risk that bonds pose because we’ve been in basically like an entire generation, maybe two generations’ worth of a bull market for bonds. So, people think bonds are this very, very safe thing. But historically, bonds have actually created a lot of deep risk. A good example, World War II, both like during and after, Germany and Japan, the stock market for both of those was down about 90%. But you’ve recovered within 10 to 15 years. Okay, so that turned it actually that equity was a shallow risk. But the bond portfolio that you were in was down 95% and basically turned into worthless pieces of paper and that became a deep risk.

So here, you have two countries but different flavors of investment that created different risk profiles. And I think people right now, because of such a long run of good returns, mostly capital appreciation, which is not what you should probably be chasing with a bond portfolio [chuckles] but here we are. They’re probably not thinking, I think, enough about that type of risk that their bonds pose. And Buffett’s done a good job of talking about that in– When did that paper come out? He wrote that op-ed. I think it was like maybe 2014 or something like that, where he talks about–

Tobias: The emissions one?

Jake: No, he talks about– or maybe is that– I can’t remember if it’s also in there– [crosstalk]

Bill: This dude’s [crosstalk] anyway. Why are we talking about him?

Tobias: What’s Davey Day Trader saying?

Bill: Yeah, come on, yeah.

Jake: Yeah. Where’s Davey Day Trader on deep risk?

Bill: [crosstalk] What’s your opinion on [crosstalk] again?

Tobias: Stocks only go up.

Jake: Well, what I would maybe tell him is Japan from 1990 to 2013, what was the real return for Japanese large-cap companies?

Tobias: I would guess negative. Negative 2% a year? Maybe negative 1% a year?

Jake: Billy, what do you got?

Bill: No, I got nothing, man. Nothing worth guessing, but I’ll go with Toby. Toby knows this shit.

Jake: So, I don’t know if that’s right in the compounding, I’d have to do the math, but the total was negative 58%.

Tobias: Okay, so– crosstalk]

Bill: Whoa!

Jake: You put in 23 years and cut your money in half over that time period in real returns.

Bill: Yikes!

Tobias: You can do that with value right now.

[laughter]

Bill: Yeah, why not? I could just buy a value basket. [laughs]

Jake: Yeah, exactly.

Bill: That’s a good joke, Toby, well done.

Tobias: [chuckles] Yeah, I’m living that reality.

Bill: [laughs]

Jake: Yeah. One of the things that Bernstein says it’s interesting is that, these different time periods– over the short term, shallow risk is more on your mind, but then– let’s say less than 10 years, but then after 20, 30 years, the deep risk is more In your mind. And what’s hard is that in-between period of the 10 to 20 years, that’s where it switches between the two. And that’s where it takes some real talent to understand the risks, like what are the bigger risks that you’re facing between those two.

Let’s talk about like the first possible one, that’s a severe prolonged hyperinflation, which has happened lots of times. Interestingly enough, equities tend to do pretty well actually. Not as far as like actual big returns, but they tend to keep purchasing power, or at least not lose that much. Even in some South American countries that are often cited for their crazy hyperinflation, their equity markets tended to return not that far off of even what longer-term returns would be for an equities portfolio. So, the nominal return is huge.

Tobias: So, they look great on nominal basis, yeah.

Jake: Yeah.

Tobias: Yeah, that’s what I was going to ask.

Jake: But real is pretty modest, but not compared to paper or bonds, which you’re absolutely getting devastated by. Different ways of mitigating that are obviously like an international portfolio of equities, tips, gold potentially. And then also even just something as vanilla as your fixed-rate mortgage if you can get it at a good price, that’s actually a pretty good play. The severe–

Tobias: Can I just ask just before you move on?

Jake: Yeah.

Tobias: Tips. What inflation rate do you get with the tips? How is that calculated? Who calculates that?

Jake: I think they’re CPI linked, aren’t they? So, they’re probably always trailing reality.

Tobias: So, I’d say it’s a little bit game then, so there’s probably a way to trade that run. Anyway.

Jake: I don’t know. Actually, Bernstein in another book talks about this and doing like a laddered tips approach as for your retirement has been a pretty reasonable way of going about it. Trying to duration match what you need with what your assets look like. I find that to be an interesting idea. Can we move on?

Tobias: Yeah, sorry.

Jake: A severe prolonged deflation– deflation, when you talk about that, it’s really means an economic disaster depression type. That is much more rare compared to the inflations actually, especially for a long duration one. Cash and bonds and gold tend to do better than equities. Confiscation taxes, the way around that is actually foreign domiciled assets, whether it’s you own property somewhere else, also contingent with that is having a good escape plan, that’s one of the things he talks about. You have to be able to potentially get out away from being confiscated. Actually very hard in the US.

We have these expatriation taxes where even if you tried to bail, they’re going to try to take their cut, no matter what. The US is pretty mercenary compared to even other countries. Uncle Sam is like a good bookie.

Tobias: But you’re not escaping the US unless there’s some regime change. Maybe they fixed that law.

Bill: Meanwhile, though, I got a buddy that’s in Dubai and he doesn’t pay any income tax on anything he makes. I don’t understand it.

Tobias: If he’s American, he’s got to pay in States.

Bill: Oh, I’m not trying to out him. But I’m not sure he’s doing it.

Tobias: They’ll track you down.

Bill: [laughs] Yeah, well, okay. All right. [crosstalk]

Tobias: They tracked me down is a noncitizen when I was earning here in 2004, I think a long time ago. And when I got back to Australia, they sent me a note and I was like, “Eh, not a citizen.”

Bill: Really?

Tobias: Yeah.

Bill: Huh. Now you’re here and you just said that?

Tobias: I’m back. Now, I’m a citizen. Now, I have to pay– [crosstalk]

Bill: I guess statute of limitation is– [crosstalk]

Tobias: Well, I wasn’t a citizen at the time. But they’re just– automatic machine just figures out who you are, where you are, sends you a notice, and then you’ve got to figure it out.

Bill: Huh.

Jake: Yeah. So, the last one is that devastation and that’s like wars and things like that. Also, geographically diversifying your assets is one way to hold some of your purchasing power against potential– actually like physical assets that the companies maybe you’re invested or owned getting bombed to smithereens. Also, probably an escape plan is a good idea in that one as well.

Tobias: So far, I’m hearing fanmag and Bitcoin.

Jake: Yeah. Probably. The market sniffed that out a long time ago.

Tobias: Yeah, we’re behind the curve on that one.

Jake: So, here’s an interesting question for you. 1899 to 1949, first half of the 20th century, what do you think that global equities portfolio real returns look like?

Tobias: Over what period, sorry?

Jake: 1900 to 1950, let’s say.

Tobias: I’d say they’re pretty good, I’d say they match. We’re seeing global or international XUS?

Jake: No, this includes US, I think this is just a global portfolio– basically owning businesses around the world.

Tobias: Pretty good. I’d say probably comparable to what the States did, I’d say probably you’re getting 9% or 10%, something like that.

Bill: Yeah, I don’t know. I’m just trying to think through, and this is tough. You’re like right after World War II, so you’ve got some pretty bombed out economies but it’s probably mostly– I don’t know, 6%, 7% per annum?

Jake: 2.8%.

Bill: Ooh! [crosstalk]

Tobias: A real?

Jake: Real.

Bill: Real, who does [crosstalk] real.

[laughter]

Jake: Good point.

Bill: How the game’s played, loser!

Jake: Yeah, real is for suckers. Real is if you actually need it to like, buy groceries–

Tobias: If you’re going to live on it.

Jake: –and stuff. Like a real pleb–

Tobias: That’s the only time that matters, when you’ve go to live on– calculating returns to do that nominal–

Jake: Yeah, that’s a good point. Real is for suckers. All right. So, then 1949 to 1999, what do you think that the real returns were?

Tobias: Well, like I said, I’d say 9% or 10%. Real? Hang on. No, real 6% or 7%?

Bill: Yeah, that’s where I would go. I go closer to 5% to 6%.

Jake: 8.5%. We’re looking at pretty big differences in a 20th century that was considered pretty favorable for equities. So, I guess the question then is does 2000 to 2050 look more like the first half of the 20th century or the second half?

Bill: I’m just going to go bottoms up and avoid all this crap. I’m not smart enough to figure this stuff out.

Tobias: Yeah, I think it’s hard because I think the US is expensive but I think the rest of the world is pretty cheap. But then, the US has better businesses on average, or better businesses in the index at least, for the most part. It’s really, really hard but I think [unintelligible [00:29:33] is probably more likely.

Bill: Well, the point about bonds and whatnot like, I spend how long being, “Oh, bonds make no sense, bonds make no sense.” And then in March, it looked like for a second, debt holders were going to own all the equity of every cyclical company. I don’t know.

Jake: We don’t do that anymore here.

Bill: Yeah. Now we’ve got that– [crosstalk]

Jake: –money. All right. So, last little thing that I found interesting in there is, he’s talking about– [crosstalk]

Tobias: Are you going to give us the answer for the next 50 years?

Bill: Yeah, what’s going on? You don’t get to get on these, you just float the questions, huh?

Jake: That’s right. Being a professor has its privileges.

[laughter]

Jake: If gun to my head, I would say it’s got probably looks more like the first half of the 20th century than the second. All right, so last thing. If you’re a younger investor, you should be worrying about the deep risk, but actually seeking out the shallow risk, which is when prices tend to be lower. That’s when you’re going to be accumulating more, which is common sense, I think. But people don’t really frame it in a shallow risk, deep risk kind of way.

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