Understanding deep risk in a portfolio
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In your latest e-book, you talk about various types of risks, and you distinguish between what you call "deep risk" and "shallow risk". Can you differentiate between those two types of risk?
Bill Bernstein: Let's start with shallow risk. That's normally what we think of as risk--the stock market goes down 30 per cent or 50 per cent or 55 per cent or, as it did in the Great Depression, almost 90 per cent. But it recovers and, in fact, the US market has recovered every single time it's done that in the past 200 years.
It doesn't mean it's always going to happen in the future--and that's deep risk. Deep risk is the possibility that you may lose a substantial amount of your real assets in an asset class for a period of at least a generation. The poster child for that, of course, these days, is Japanese equity.
In the book, you call the four big causes of deep risk the "four horsemen." Let's take them one by one. You mentioned Japanese equity. So, let's start with the risk of deflation.
Bernstein: The Japanese really haven't suffered deflation during the past 25 years. Their CPI is more or less flat over that period of time. But in the modern era of fiat money, that's deflation enough.
The way you protect yourself against deflation, interestingly, is to own gold. Gold, it turns out--and this is very counterintuitive--is a much, much better hedge against deflation than it is inflation, and the reasons for that are interesting.
Deflation is usually caused by a financial crisis or severe financial instability and dysfunction. People start to lose faith in the banks--what do they buy? They buy gold. Gold historically has not been a great hedge against inflation, and all you have to do to think about that is consider what happened in Brazil, which had severe inflation during the '80s and '90s--a period during which gold lost 70 per cent of its real value. So, if you were a Brazilian and you thought that gold was going to protect you against inflation, you had another guess coming.
Moving on to inflation, which you hinted at, gold is not such a great hedge against inflation. Before we get into ways to protect your portfolio against inflation, let's talk about why you think that really is the major deep risk that investors ought to be concerning themselves with.
Bernstein: Because it's so pervasive in history--every single country in South America has experienced severe inflation--all you have to do is look at the European and far-eastern currencies that preceded the euro and ask, "How many of them stayed intact to something that people could actually buy something with?" And the answer is there's really only three or four currencies that fit that: the Dutch guilder, the English pound, the American dollar, maybe the Canadian dollar and a couple of other smaller countries' currencies.