Academy Login

Inflation, Deflation, Confiscation & Devastation- The Four Horsemen Of Risk

Noted financial advisor and historian William Bernstein makes a compelling case for stocks in his e-book Deep Risk: How History Informs Portfolio Design. In the introduction, Bernstein begins by offering an operational definition of risk. Risk is the size of real capital loss times the duration of real capital loss. This gets at the idea that it is a permanent, rather than a temporary, loss of capital that that is most damaging to investors. Magnitude and duration of loss are both relevant factors. Mistiming the markets, by buying high and selling low, is the most common method whereby an investor sees this risk manifested, as this is the clearest way to experience a permanent loss of capital. A more disciplined approach to investing is needed to avoid this risk.

This definition allows Bernstein to identify two flavors of risk: shallow risk and deep risk. Shallow risk is the loss of real capital which recovers within several years, while deep risk reflects the permanent loss of real capital. It could be defined, for instance, as a negative real return over a thirty-year period.

It becomes apparent that stocks are risker than bonds with respect to shallow risk, but that the opposite is true with respect to deep risk. Throughout the world in the twentieth century, fixed-income investors have suffered permanent losses in inflationary storms which equity investors were better able to avoid. As Bernstein says, absence of leverage and with sufficient liquidity, retirement savings are not wiped out by too high of standard deviation, but rather by real-world events.

With deep risk, once one has become properly insured to personal vagaries and carefully disciplined with respect to strategy and approach, the four big threats over long horizons are:

  1. Severe and prolonged high inflation
  2. Prolonged deflation
  3. Confiscation
  4. Devastation

The remainder of his book focuses on these four risks in terms of what damage they do, how likely they are to happen, and what strategies provide the best chance to mitigate the threat. Relevant here are the probabilities, the consequences of the hardship created, and the costs of protection.

First in terms of the probabilities that each threat will manifest, inflation is high, confiscation is medium, and deflation and devastation are low. Inflation, though high in probability, has a lower cost for protection. It is the most relevant for retirees to worry about, but it is also the least catastrophic for a globally diversified investor. It is the easiest to protect against with international diversification, TIPS held to maturity to match spending needs, delaying Social Security, and an inflation-adjusted annuity. A globally diversified stock portfolio is most effectively protected from the deep risk of inflation, though stocks do exacerbate shallow risk. Meanwhile, unexpected inflation devastates traditional bonds.

Deflation, on the other hand, is the least likely to happen. It is good for bonds and bad for stocks. Solutions include cash, bonds, and international diversification, as well as gold. But using bonds and bills carries a high cost if we experience inflation rather than deflation.

As for confiscation and devastation, the best defenses are holding foreign assets and having a means for escape. He argues that confiscation is a likely deep risk as taxes will likely increase in the future.

Bernstein’s conclusion is that the best long-term defense against deep risk is a globally diversified equity portfolio with tilting toward value and precious metals and natural resource companies, TIPS, and potentially some gold and foreign real estate. Because of inflation, bonds become riskier than stocks over long horizons, while shallow risk makes investors with shorter time horizons more vulnerable with stocks. For lifetime financial planning, determining how to transition between deep risk and shallow risk at different points in the lifecycle is one of the greatest challenges facing wealth managers.

Stocks have historically provided a return premium above what is available from holding bonds. This has historically allowed stocks to provide a higher return than bonds. Though this premium is risky and may fail to materialize, many investment analysts are comfortable with the idea that over long time horizons, stocks can reasonably be expected to continue their outperformance.

This does certainly speak to the idea of including a healthy dose of stocks within an overall retirement income strategy, but the question remains about how reliant one should be on the stock market to cover the day-to-day expenses of retirement.

To find out more about the most important risks to your retirement, read our ebook the 7 Risks of Retirement Planning.

This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.

Are You Ready for a Challenge?

Register to attend our FREE 4-Day Retirement Income Challenge event on March 4th – 7th from 12:00 – 2:00 PM ET each day.

Click below to learn more and reserve your spot!