The Investment Scientist

Deep Risk vs Shallow Risk: William Bernstein’s Take

Posted on: December 27, 2013

images-46Following the post I wrote about deep risk vs shallow risk, I went to Amazon and flipped through Bill Bernstein’s latest book “Deep Risk” to see if he feels the same way as me.

It turns out there is a lot that we agree on, but not everything.

Here’s where we see eye to eye: 1) our definitions of deep and shallow risks are almost the same: 2) we both see market fluctuation as a shallow risk and 3) we both see inflation as the #1 deep risk.

Our agreement stops there however. Bernstein does not seem to believe behavior risk and agency risk are deep risks, as I do. Instead, he mentions the following three risks as deep risks in addition to inflation risk.

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Deflation Risk

Immediately this brings to my mind the example of Japan. In 1987, Nikkei was 38000, now it is 15000. Twenty six years after their asset bubble popped, Japan’s stock market value is still only 40% of its peak.

This risk is unlikely to repeat in the US though, since our Fed is so adept at printing money. On top of that, this risk can be hedged by buying long term bonds.

Confistication Risk

This immediately makes me think of China. Before the communist revolution, China had the earliest and most vibrant stock market in Asia. After the communist revolution, the market closed down and production assets were confiscated.

This risk is also quite unlikely to repeat in the US, though a less extreme version of it might still occur. Namely, taxation. That’s why having good tax planning is crucial to avoid confistication risk.

Devastation Risk

My former supervisor who is a Syrian American, invested his wealth in his home country and the recent war just wiped out literally all his wealth!

If it’s not war, then it could be a tornado, a flood, a wildfire or an earthquake which could wreak havoc on one’s investments. Luckily, most of these risks, with the exception of war, can be insured.

As for the risk of war; with the #1 defense budget in the world, I feel it’s safe to say that we’ve pretty much transferred that risk onto other countries.

I don’t disagree with Bernstein necessarily, but I still think that for US investors, the most damaging deep risks are: inflation risk, behavior risk and agency risk.

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

Twitter: @mzhuang

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