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3 Aspects of Risk

Destruction, volatility, and uncertainty.

John Rekenthaler, 09/27/2013

Destruction
Yesterday's column highlighted one aspect of risk: the possibility that an asset becomes destroyed (either fully, such as by a government confiscating assets, or partially, as in a large inflation-adjusted loss sustained over multiple decades). The source was Bill Bernstein, who listed "four horsemen" of destruction: hyperinflation, severe deflation, government confiscation, and war/devastation. To Bernstein, an investment adult is one who worries less about monthly fluctuations and more about avoiding catastrophes. 

Bernstein is hardly the first to separate long- and short-term considerations. Many have distinguished between "risk," meaning the former, and "volatility," meaning the latter. Indeed, such an argument was commonly made by motivational speakers in the 1990s, who urged financial advisors to keep the faith with equities and to keep putting their clients into stock funds.

I recall such a presentation in 1997: A gentleman named Nick Murray held up a 3-cent postage stamp to a crowd of financial advisors. He then asked them a stamp's current cost. Forget researching investments and building fancy strategies, said Murray. Just show clients the 3-cent stamp and get them into stocks. When the clients called in the future, worried because stocks were declining, show them the stamp again. While he didn't phrase the matter in that way, effectively Murray told his listeners to worry more about the first of Bernstein's four horsemen, (hyper)inflation, and less about monthly fluctuations. 

(Yes, Murray hawked an asset near its top. That's what motivational speakers do. His advice worked out pretty well, though. Although the danger of inflation never materialized, and stocks hit two very rough patches during the Oughts, equities nevertheless are up 80% in real, inflation-adjusted terms since Murray gave that speech. I'm not sure that Murray's stamp trick would have kept the new stock-fund owners in the market during the downturn, but that's another story.)

Bernstein has taken the argument much further, of course. Rather than discussing only purchasing power or--worse yet--engaging in numerology by showing how different assets perform over different time horizons without explaining why, Bernstein has established a framework for categorizing and quantifying the risk of asset destruction. He doesn't go so far as to put a percentage on the possibility of each horseman (happily so, as that would be hubris), but he does argue for the relative probability of each event. He also walks through which assets would fare best under each scenario.

My contribution to this discussion, perhaps, can come with nomenclature. The traditional distinction between risk and volatility is misguided. Per the section below, volatility is very much a risk. Let's make risk the general term, with destruction, volatility, and uncertainty being three of risk's subsets. Risk is the danger that anything unpleasant might occur to a portfolio. Those three items are different types of unpleasantness.

Volatility
That volatility receives short shrift in Bernstein's framework does not indicate that it's to be ignored--quite the contrary. For one, not everybody has the financial means to be an investment adult. Riding out the market's storms requires more than just the mental attributes of investment knowledge and psychological strength. It also requires not being forced into a sale at the wrong time. Volatility is the major risk for assets that will likely be traded over the next few years.

And don't underestimate the mental challenges caused by volatility. Bernstein shows how a wealthy hypothetical retiree in the early 1930s, holding a seemingly safe 75% stock/25% bond portfolio (the retiree's withdrawal needs were quite modest, thereby affording the relatively aggressive asset mix), would have almost certainly been shocked into selling off stocks near the market bottom. As it turned out, after several devastating years of equity losses, that hypothetical investor could have survived by staying with the original plan. But he realized that only in hindsight. At the time, facing ruin if but one more year were bad, that investor would almost certainly have bailed.

is vice president of research for Morningstar.

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