Tuesday, 24 December 2013

What are the important long term investing risks? (Volatility is NOT one of them)

Last week's post on the riskiness of stocks in the long run highlighted the fact that historically equities have performed very well over long holding periods despite being subject to massive gut-wrenching declines in the short term. Today we'll look more closely at the long run risks that can cause significant permanent loss of capital even to stocks (i.e. no bounce back happens!), as laid out in Deep Risk, William Bernstein's new, very readable, mini book. Importantly for investors, equities, bonds and cash / T-Bills behave differently in response to long term risks, which he calls Deep Risk, than short term risk, which he terms Shallow Risk. It's evident that figuring out our own investment horizon is critical to building a portfolio to cope successfully with the relevant risks.

What is long term?
Bernstein means 30 years or more, a very long time but still well within an investor's lifetime horizon, even a retirement horizon nowadays.

What does he define as risk?
It's not a statistical measure like standard deviation; rather, it's an intuitive yardstick focused on the downside, permanent loss of capital, meaning a negative real after-inflation returns after 30 years. Shallow risk happens when the loss is recovered within a few years, such as the 2008 equity market crash. That's what volatility is and where it fits into the risk picture - a short term drop that is quickly recovered. Deep risk is when there is permanent loss. Finally, the measure of risk includes its magnitude - a small though though permanent loss doesn't matter much. It's losses big enough to be devastating to the investor that matter.

The devastating long term Deep risks and the effect on major asset classes
1) Inflation = Hyper/High 8+% price rises sustained for many years. Low steady inflation such as we have been experiencing in Canada for the past 15+ years, doesn't hurt any of the major asset classes.
  • Losers: long term bonds, T-Bills
  • Winners: equities, especially commodity producers, real return bonds
2) Deflation = Sustained economic stagnation with associated falling prices, such as the Great Depression of the 1930s. Bernstein thinks that this particular risk is much less likely today since most episodes of deflation, including the 1930s, happened when the world operated on the gold standard and now central banks can counter deflation by printing money.
  • Losers: equities
  • Winners: long term bonds, T-Bills, gold gold (now that's a surprise since the popular image is that gold protects against inflation but he cites data showing that it counters inflation poorly; author and financial analyst James Montier comes to same conclusion in No Silver Bullets in Investing; gold is portrayed as worthwhile insurance for times when investors have lost faith in the government, which is more typical of severe economic depressions)
3) Confiscation = Government takes your money, giving pennies on the dollar for assets, or hikes taxes to levels of expropriation. High debt levels and large growing fiscal deficits of governments are obvious warning signs of possible government desperation that might incite confiscation.
  • Losers: potentially anything can taken, when governments are desperate, nothing is sacred
  • Winners: foreign-held assets that your own government cannot grab, such as property; alternatively, leaving for another country that will not confiscate assets can work but it's a drastic measure
4) Devastation =  War which destroys capital and people. It's the ultimate bad outcome for an investor. Some forms of worldwide devastation, such as potentially harmful climate change, which he names, or pandemics, may offer no place to hide. In that case, total permanent loss of investments wouldn't matter anyway.
  • Losers: no assets are safe
  • Winners: foreign assets if the conflict is localized
Of course, in addition to the severity of harm, the likelihood of the threat must be taken into consideration. The good news is that for Canadians, the most likely threat is inflation. With a central bank ever ready to keep deflation at bay by printing money, with a government financial situation among the best in the world and with a stable civil society offering relative peace, inflation is the prime menace. It too seems to be relatively benign at the moment. So, as investors and as citizens, we have much to be thankful for at this holiday time.

Bernstein's parting words are simple and direct: "This booklet's primary advice regarding risky assets is loud and clear: your best long term defense against deep risk is a globally value-tilted diversified equity portfolio, perhaps spiced up with a small amount of precious metals equity and natural resources producers, TIPS [which are the US version of real return bonds], and if to your taste, bullion and foreign real estate." It's interesting that the TSX Composite index is already quite "spiced up" with a heavy weighting in precious metals and resources producers (11+%, vs only about 3% in the US total equity market), so investors with a broad Canadian equity holding like iShares S&P/TSX Capped Composite Index Fund (TSX symbol: XIC) have that part accomplished naturally. Another reason to count ourselves lucky!

Bottom line
The cautious investor has two main action takeaways from a look at long term risks:
i) Match investment assets and spending liabilities - control risk by matching a) near term spending plans with assets that can easily be cashed and are not subject to volatility, which is the main short term risk (e.g. T-Bills, GICs, money market funds, short duration bonds) and b) longer term spending, like a distant retirement, with assets that cope well with the biggest (impact x probability) long term risk - equities.
ii) Diversify - since most people have multiple investment goals and therefore spending horizons, it makes sense to keep some of the several types of assets.

Merry Christmas to readers!

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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