How risky does investing get?

All investors know that they need to take risks in order to achieve returns higher than cash. If you asked investors if equities were more risky than cash, most would agree; but that depends on how one understands risk.


The investment industry has done a poor job of explaining risk as it relates to an investor and tends to equate risk with return volatility.  William Bernstein – a neurosurgeon-turned-adviser and prolific investment writer – wrote a great, short booklet on risk, where he explained the different risks that equity investors face, as follows:

“Risk, then, comes in two flavours: “shallow risk,” a loss of real capital that recovers relatively quickly, say within several years; and “deep risk,” a permanent loss of real capital.”

We’d add in another level – mid-depth risk.

Shallow risk – precipitous equity market crashes that recover relatively quickly

This first level of risk is the one that most investors focus on, yet is perhaps the least relevant, particularly for those with long investment horizons.  These are the scary and emotionally fraught times when equity markets fall dramatically, the latest example of which was the Credit Crisis of 2007 to 2009. 

The chart below shows the five largest equity market falls in the US market since 1927 (in US$ terms).


Data source: Ibbotson SBBI US Large Stock TR, Jan-25 to Apr-17. Morningstar © All rights reserved.

Mid-depth risk – relentlessly disappointing returns

We see mid-depth risk as a prolonged period of disappointing market returns – perhaps over 10 years or more - after accounting for inflation. These periods do exist, as the chart below illustrates for US equities since 1955.


Data source: Ibbotson SBBI US Large Stock TR, Jan-55 to Apr-17 (in real terms)

For those in the accumulation phase of investing, this is less of a problem as subdued markets allow them to make regular contributions at lower market levels.  Warren Buffett captured this nicely when he wrote, in his 1999 letter to Berkshire Hathaway shareholders:

"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the 'hamburgers' they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

Deep risk – a permanent loss of wealth

Bernstein defines deep risk as the permanent loss of purchasing power on account of four events: hyperinflation, such as that of the Weimar Republic, where from 1921 to 1924 bonds and cash lost nearly all their value; prolonged deflation causing a depression and high unemployment; devastation i.e. wars and geopolitical events, such as the Bolshevik revolution (almost 100 years ago to the day) resulting in the closure of the Russian stock market and default on Tsarist government debt; and finally confiscation, which still happens today, for example the Argentinian government’s expropriation of the Spanish oil company Repsol’s assets in the country in 2012.

There are two investment behaviours that translate shallow risk into deep risk. Being shaken out of the market by a precipitous rapid fall (shallow risk) and then failing to get back in again – as there never seems to be a good time to do so - crystallises a real loss (deep risk).  Owning concentrated stock portfolios can do the same; a recent study in the US shows that 26,000 listed companies have been in and out of the US equity exchanges since 1926, with a mean life of only seven years.  Only 36 companies have made it through from 1936.  Owning high exposures to stocks that fail is deep risk.

The best mitigants of deep risk are to own a globally diversified portfolio of several thousand stocks distributed predominantly across developed equity markets of democratic countries with a sound legal frameworks.  Equities provide the prospect of strong, long-term inflation-plus returns. 

Investors know that placing money in the bond and equity markets carries risk.  Yet the way in which many look at, and measure, risk is disconnected from investors actual longer-term investment horizons, focusing on shallow risk, rather than deep risk.  Unless one understands the probability of an adverse event (hazard) happening and the effect of this exposure, due to a specific hazard on the individual investor, then it is likely that the real risks faced by an investor are masked by the shallow risks that have more emotional impact.  Owning more ‘low risk’ bonds (or cash) is not necessarily always the right answer when trying to avoid the deep risks that investors face.

To explore this topic in more depth, download Volume 38 of Acuity – How deep is your risk?