Risks and Antidotes

Investing is simple but not easy. Just like a diet is not hard in theory. Eat more green, consume less and exercise. Yet many of us fail to follow these 3 simple rules.

Success in personal finance seems so hard from the outside until you start doing it. Show up, work harder, spend less than you make and invest the difference in income-producing assets.

This simple advice may even sound stupid or naive. But oh boy, does it work. There are no shortcuts to getting rich. Don’t take it from me, take it from people who have made it.

When it comes to investing, Bernstein is probably my favourite author. He has written some must-reads like the Four Pillars of Investing, the Intelligent Asset Allocator and Rational Expectations among others. I’d like to summarise a few timeless investment pearls I took from him that’ll pay dividends over time (pun intended!).

The goal is to understand the risks behind investing and build a portfolio mix that’ll serve us well.

Do you have enough for the ride?

Investing is simple but not easy. There are good times and there are bad times. We spend most of the time swinging between those two, but most of the time, the world is getting better even if it doesn’t feel like it.

We had the best decade in human history then Covid struck. Now things are improving again slowly but surely.

In good times, everyone feels like a genius. But in bad times, you need to have enough cash and high quality bonds to weather the storm. Riskless assets.

  • Do you have enough cash to pay for your BTL mortgage for a  6-month void period?
  • What if interest rates rise by 1%?
  • What if you lose your job on top of it which is more likely to happen especially during the bad times?

Enough “margin of safety” to use Ben Graham’s words.

Ideally, we want assets that retain their value or even increase when the economy is in bad shape. Peer-to-peer lending is not riskless. Corporate bonds are not riskless. Cash and UK government bonds are. Preferably low duration.

The easiest money is made particularly when there’s blood in the streets. When everyone wants to sell at any price and it feels like the world is ending. Assuming, of course, you have enough dry powder to be on the buying side.

Cash not only pays the bills but actually lets us buy those risky assets on the cheap when everyone wants to get rid of them.

Understanding deep risk and shallow risk

There are different ways to define risk. Talk to an academic or to a fund manager and they’ll probably define it as “volatility”. How much movement there is in the price.

But for ‘real’ people like us, I see risk as the failure of meeting our goals. They range all the way from “getting back less than I invested” to not having enough food in retirement.

The more we understand about risks the more we can invest with confidence. It’ll also make us stronger when our investments do not perform as expected which is inevitable from time to time.

We don’t just invest our money and expect a guarantee return back. If you look at the past 10 years, this seems to be the case! But it surely doesn’t work like that.

Bernstein defines deep risk as a permanent loss of capital.

Deep Risk

Permanent loss can happen if you invest in the next meme stock. That’s probably your fault though or a product of luck. You can reduce the luck factor (and perhaps your returns too) by investing in a basket of stocks, an index fund for instance.

Permanent loss of capital can also happen when the government confiscates your assets either directly or via very high taxes. People can own gold in one click nowadays. They forget that owning gold was forbidden for 40 years in the US (1933 – 1974).

Or that Argentinians could not convert their pesos to dollars more recently (2011-2015).

Permanent loss can also happen if there’s a war and you’re on the wrong side. Also known as devastation risk.

Confiscation and devastation are risks we cannot do much about. Perhaps owning foreign real estate or more than 1 passport can help reduce them. Owning multiple bank accounts and more than one pension providers also come to mind.

I think people also underestimate having real-world skills to hedge those risks. The ability to do our own plumbing or to have modern skills in the 21st century. I am a computer engineer at heart and I am comfortable with finance and accounting.  Even if they take away my entire wealth they cannot take the seeds that built it! It can hopefully be reborn.

To a more extreme level, being able to survive with less or even without much food may come in handy in times of devastation! The concepts of financial independence such as DIY and being content are very applicable here.

But overall, confiscation and devastation happen very rarely and they are hard to hedge against. It makes sense to focus on the 3rd kind of risk which is more likely to happen if we look at history: high inflation/deflation.

In the fiat world the risks of deflation are quite low. Central banks are doing the best they can to print as much as needed in order to stimulate the economy. But the risks of high inflation are real and have occurred more frequently in the past.

High inflation, for example, happened in the UK in the 70s and from what I read it was not fun, especially for those holding cash or bonds. So much for the riskless assets I know 🙂 .

This is where holding riskless assets means trading ‘shallow risk’ for ‘deep risk’.

Shallow Risk

We know that stocks are risky because they can drop by 50% in a year. Cash and short-term high-quality bonds on the other hand, never do that. They hold their value well as the March Covid crash has recently shown us.

The 2007 crash showed shallow risk in practice. The price of UK equities (FTSE All share) dropped by 41% but recovered in just 2 years.

Cash and high-quality short-term bonds are great at protecting from these sudden drops. The 2007 crash only recovered in a couple of years. That’s nothing you may say, I have a high appetite for risk.

But sometimes stock market crashes can last for many years until they recover their previous value (inflation-adjusted).

For the UK, in particular, the downturn in 1972 saw equities reach a real negative -73% drop until 1974! It took another nine years to break even in real terms. So overall, 11 years of misery. If you’re into stock market history see this great post by Monevator and the real stock market losses for all countries and years to recover from Pfau.

Stocks. are. risky.

Shallow risk becomes a real danger to those who have a few years of work-based income left (also known as human capital). That applies equally to extremely early retirees in the FIRE crowd who are typically 100% stocks and want to retire in 3 years.

Cash and high quality bonds on the other hand can handle shallow risk well. But cash and bonds become too risky if you hold them for 20 or 30 years. They simply return a lot less than risky assets, which is kind of expected anyway.

It’s not that £10,000 will be £6,000 in 20 years. It’ll probably be around £12,200 at 1% annual return. But £12,200 will buy much less in 2040 than in 2020 because of inflation. In today’s 2% inflation world, the 1% return means our bonds are actually losing purchasing power over time.

So for that short-term safety we have to pay the price of low growth in the long term.

Things get even worse in times of high inflation, like 10-15% instead of the steady 2-3% we are used to. The Germans and Japanese bondholders saw losses of more than 95% in the high inflationary environment during and after the 2nd world war. See the Credit Suisse 2013 yearbook country profiles towards the end.

Stocks, on the other hand, lost 90% too but regained their value as companies like Siemens and Mitsubishi regained their value in about 15 years. Belgium, France and Italy saw similar patterns.

What do we learn from this? Riskless assets are crushed in times of high inflation. There’s a real risk of losing almost all our purchasing power.

Stocks suffer too in times of high inflation in the first years. But as the economy gets used to rising prices, stocks offer pretty good protection against high inflation.

What are cash and bonds good at?

Cash and bonds protect from shallow risk. The risk of sudden drops in our portfolio value (see Covid or 2008). They are perfect at being the dry powder on the side for when buying opportunities show up. They also give us safety and comfort.

Bonds are perfect for late retirees that have a 20-year horizon with somewhat expected liabilities. Not all bonds are created equal. Short-term high-quality bonds (1 to 5-year duration) are like cash. Mid-term (5-10 year) are the middle ground with some yield and somewhat higher volatility. Although an investor who could earn 6% in gov bonds 20 years ago would laugh at our ‘yield’ today.

Inflation-linked bonds or government bonds that match longer durations, like a 20-year duration can match future liabilities for soon-to-be retirees (assuming no sudden high inflation!). The higher the duration the higher the risk.

For aspiring early retirees, cash and bonds are also good at protecting from “sequence of returns risk” (think a 40-50-year-old). A 50-year-old early retiree planning for 40 years needs to make sure the portfolio doesn’t see a sudden 30-50% drop in the first 5-10 years of early retirement. Which is the actual definition of the sequence of returns risk.

That would be devastating to their future wealth and there’s a good chance the portfolio won’t make it. That’s regardless of how comfortable they are with taking risk! If there’s a 1929 crash early on and the portfolio is too aggressive, the money simply won’t last for 40 years assuming no other income like inheritance or state benefits. They need to have enough riskless assets to consume while the risky part of the portfolio recovers.

What portfolio mix should I choose then?

There is no perfect mix of risky/riskless assets. The perfect asset allocation is only known in hindsight. But it makes sense to consider where you are in your life before investing. Then adjust as you age and as you find out more about yourself and risk tolerance.

Young investors should take as much risk as they can if they plan to work until late. They have the following luxury: A stream of future paycheques that can be invested. That’s known as human capital.

As life goes on, investments grow and the human capital is reduced. There are simply fewer paychecks left until we retire but more investments to support us.

Early on, the future human capital compensates for the shallow risk of owning equities. We simply don’t care if equities go down because your human capital will make up for it. But later as we approach retirement there’s little room for error if only a handful of working years are left!

A 50% drop in a £2m portfolio before retirement is different to a 50% drop in a £10,000 portfolio when you start. The latter can actually be a blessing to the young investor.

So naturally, the rule of 100 minus your age became popular. Invest <100 – your age> in risky assets like property and stocks and the rest in riskless cash and government bonds. I like the 120 minus your age rule as I think the previous one is too conservative.

But overall, the point is this: There’s little value in discussing the riskiness of stocks without knowing what the ratio of human capital to investment capital is. The lower the ratio, the riskier stocks become.

I hope you enjoyed this article. I want to end with a nice quote from Bernstein:

The purpose of investing is not to simply optimize returns and make yourself rich. The purpose is to not die poor.

Rational Expectations (Bernstein)

Look at Dogecoin, Bernstein. Maybe you just don’t get it!

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Hi! I’m Michael and I love writing about different ways to earn, save and invest our money. Coffee addict :)

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