The Investment Scientist

Deep Risk vs Shallow Risk

Posted on: December 24, 2013

images-54Recently, a prospective client of mine sent me an email asking about my thoughts on Bill Bernstein’s new book “Deep Risk.” I have not read the book yet, but I do have my own ideas about deep risk vs shallow risk.

I define shallow risk as a potential loss that you can recover from and deep risk as a loss that you cannot recover from.

Market volatility, for example, is a shallow risk. It is very visible and it is scary, there is even a TV channel devoted to it. (That TV channel is called CNBC.)

But taking on shallow risk is how you earn your investment keep. Thus, it should not be feared, it should be welcomed.

Now what are the deep risks you should ardently avoid? I can think of three: inflation risk, behavior risk and agency risk.

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Inflation Risk

Historically, the average rate of inflation is 3%. If you keep your money in cash, you will automatically loose 3% in value a year. That sounds painless at first brush, but over the long run it’s 30% a decade, and 60% in decades when you are ready to retire. And it is a loss you will never recover from!

Behavior Risk

A doctor client of mine told me one of his colleagues loves to trade stocks. He even has a TV in his office tuned to CNBC so he can watch the market while he works.

He is mostly not aware of Berkeley professor Terry Odean’s research entitled “Trading is Hazardous to your Wealth.” On average, investors loose 4% a year to the market, due to active trading.  That’s 40% in a decade he will never recover from!

Agency Risk

This is the risk of hiring a financial advisor who is actually a Wall Street agent. To get a higher commission and generate a higher profit for his firm, be it Morgan Stanley, Merrill Lynch or UBS, he puts you in expensive funds with alluring names.

Based on my experience reviewing portfolios, investors easily loose 1.5% to agency risk. That’s 15% in a decade and 30% in two decades. This too is a risk you will never recover from!

Such are the deep risks in my book. I wonder what’s in Bill Bernstein’s.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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