Most investment advice is focused around managing risk. But what exactly is risk?
In an upcoming book, famed author William Bernstein separates the concept of risk into two categories. The Wall Street Journal reviews:
What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price; decades ago, the great investment analyst Benjamin Graham referred to such an interim decline as “quotational loss.”
Shallow risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by sharp falls in price. “Shallow” doesn’t mean that the losses can’t cut deep or last long — only that they aren’t permanent.
“Deep risk,” on the other hand, is an irretrievable real loss of capital, meaning that after inflation you won’t recover for decades — if ever.
Charlie Munger once put this slightly differently: “Using volatility as a measure of risk is nuts” he said. That’s shallow risk. “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” That’s deep risk.
According to Bernstein, four things cause deep risk: Inflation, deflation, confiscation and devastation. I’d add another: Extreme valuation.
For the market as a whole, deep risk has presented itself only a few times in the last two decades: stocks in 2000, real estate in 2006, and (likely) precious metals in 2011. In each case, valuations were nearly double (or more) above historic norms. And in each case, it could be a decade or more before losses are recouped. This is very different from the market’s normal wiggles. You can ride out shallow risk. Deep risk leaves permanent scars.
The deep-versus-shallow risk comparison is a reminder that we often lump investing concepts into a single category when the reality is more nuanced.
There’s another investment concept that we mistakenly conflate all the time: bubbles.
There are two types of bubbles: Income bubbles, and valuation bubbles. They are entirely different.
An income bubble is when a company’s valuation might look reasonable, but the way it’s making money is perverse and unsustainable. Bank stocks last decade are a perfect example. Citigroup Inc (NYSE:C) looked like a decent investment in 2006. Twelve times earnings, two times book value, 18% return on equity, and a 4% dividend yield. Those are respectable numbers. But the way Citigroup Inc (NYSE:C) was earning money — packaging and selling the most asinine mortgage loans ever created — was dangerous and unsustainable. That was the bubble.