Deep risk, or a substantial loss of real assets over a period of at least a generation, can be caused by deflation, inflation, confiscation, or devastation, says author Bill Bernstein.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Bogleheads Conference joined by Bill Bernstein. He's an investment expert and author.
Bill, thank you so much for being here.
Bill Bernstein: My pleasure, Christine.
Benz: Bill, in your latest e-book, you talk about various types of risks, and you take pains to distinguish between what you call "deep risk"--and that's the title of your e-book--and what you call "shallow risk." Let's start by differentiating between those two types of risk.
Bernstein: Well, let's start with shallow risk. That's normally what we think of as risk--the stock market goes down 30% or 50% or 55% or, as it did in the Great Depression, almost 90%. But it recovers and, in fact, the U.S. 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.
Benz: You go through, in the book, the four big causes of deep risk--you call them the "four horsemen." Let's take them one by one. You mentioned Japanese equity. So, let's start with the risk of deflation and how concerned U.S. investors should be when they think about protecting their portfolios from deflation.
Bernstein: In the first place, 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 not only to own long government bonds but also--curiously enough--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% 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.
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Benz: Before we leave deflation, you mentioned long government bonds as a way to protect yourself. From a behavioral standpoint, though, long government bonds are very volatile. Would you recommend that investors hold individual bonds so that they are not experiencing directly that price volatility that might come along with owning a long-government bond fund?
Bernstein: Well, I don't believe--and this perhaps is getting a bit ahead of myself--in holding long government bonds. I think the return/risk characteristics are very poor. The expected returns are low, and the risks are enormous. I think that when you own government bonds, you really only have to buy one. You don't have to own a mutual fund; just buy yourself a long Treasury if you really want to do that. The reason why I don't think it's worthwhile protecting yourself against deflation by doing that is because deflation turns out to be really quite rare. And let's face it: Governments know how to cure deflation.
Benz: 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; there's the Dutch guilder, the English pound, of course the American dollar, and maybe the Canadian dollar and a couple of other smaller countries' currencies. But if you look at Japan, for example, the Japanese yen could buy something in the year 1912; it can't buy anything now. Think about what the Italian lira was valued at before it finally gave way to the euro. Look at the French franc before it gave way to the euro; it wasn't the original French franc, which was worth a $0.25. It was devalued--I'm forgetting whether it was by a factor of 100 or 1,000--in the 1950s. So, inflation is far more common than the absence of severe inflation.
Benz: So, if gold is not such a great inflation hedge when you look at the data, what are the categories that investors should consider if they want to ensure that their portfolios have some inflation protection?
Bernstein: Stocks--particularly a broadly based portfolio of domestic and foreign equities. Stocks, after all, are a store of real value. These companies have real estate. They have factories. They produce products whose value more than keeps pace with inflation. And this is borne out empirically in the data. When you look at the large number of countries that have had severe inflation, in general, stocks when you include dividends at least keep their real value and, in many cases, have very high returns. For example, during the period of the Weimar inflation from 1920-24, this was the famous "wheelbarrow period" of inflation. Stocks actually went up about 60% in real value, even before dividends. Israel and Chile have both had severe hyperinflation during several-decade periods, and yet they had returns that were probably greater than those of U.S. stocks in real terms. So, it's a fine hedge against inflation. Now, stocks in the short term do poorly with inflation; but over the long term, they do very well.
Benz: Are there any specific subcategories of equities--say within the U.S. market--that would tend to be more protective in the face of inflation than others?
Bernstein: Those that produce commodities. I'm not a big fan of commodities futures-funds; I think there are a lot of things wrong with them, both theoretically and practically. But you can get good, long-term exposure to commodities by owning the shares of the commodity producers themselves--so that's oil stocks, gold stocks, and base-metals producers as well. Those stocks, during inflationary periods, have higher returns than the market.
Benz: In terms of fixed-income instruments, obviously the nominal bonds would be poor performers in the face of inflation, but Treasury inflation-Protected Securities kind of set up to protect against inflation. Let's discuss the pros and cons of those investments as inflation fighters within a portfolio.
Bernstein: I don't know what to make of TIPS these days. You can go out 30 years and get a little bit more than 1%. Historically, that's still a low yield. On the other hand, if you're defeasing liabilities out beyond 20 or 30 years, they're probably not a bad thing to own. I think that we'll see higher yields in the future, and I would be patient. But I also wouldn't object strongly to someone who made a case for buying them right now.
Benz: You discussed a couple of other risks and the role that they might play or the effect that they might have on a portfolio. One would be the effects of a military catastrophe. You offer some ideas about how important that should be in shaping investors' portfolios--that type of risk.
Bernstein: Well, before we get to those two, let me dispose of the deflation issue because it's not just how you insure, it's how expensive it is to insure against. And if you believe that inflation is far more likely than deflation, then insuring against deflation becomes extremely expensive because the way you do that is with long bonds, which are really going to get savaged during the more likely case. So, deflation is very expensive to insure against.
It's gotten a lot harder to insure against confiscation, especially if you're a U.S. citizen. If you renounced your citizenship, the government will take 40% of your assets. And if you even legally, as an American citizen, invest abroad and you don't dot every "i" and cross every "t," if you're lucky, you're going to get off with a big fine. You may wind up with a felony conviction if you do it in the wrong way. So, it's a highly risky thing.
If you want to own assets abroad, put gold in a vault because there's no financial trace of that, and also if you don't sell it, there is no financial transaction. So, even legally you really don't have to report it. And if you've always wanted to have a flat in Paris or Rome, now might be the time to buy because real estate is something else that Uncle Sam would find very hard--although not impossible--to take away. And as far as devastation goes, what I recommend is the purchase of a good interstellar spacecraft with an efficient warp drive.
Benz: Bill, it's a really thought-provoking e-book, Deep Risk. Thank you so much for being here to share your insights.
Bernstein: My pleasure, Christine.
