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April 20, 2014

Evaluating investment risk always important

There is no such thing as a risk-free investment. Investors are exposed to many different types of financial risk but in the simplest terms everyone faces two fundamental types when investing for a future goal.

The first is market risk or the risk that adverse market conditions will cause portfolio losses. The second is purchasing power risk that describes the erosion in value of both assets and income due to inflation. Investments in financial securities, especially stocks, have over long time horizons generated returns in excess of inflation but have experienced periods of sharp and painful declines in value. Funds left in the bank or a CD, on the other hand, are largely immune from market turmoil, but are almost guaranteed to suffer real (after-inflation) losses especially over long periods of time and after accounting for taxes.

In his most recent book (available, in electronic format only), Deep Risk: How History Informs Portfolio Design, noted author and financial expert William Bernstein focuses on the risks facing long-term investors. He reframes market risk and purchasing power risk as shallow risk and deep risk respectively.

In simple terms shallow risk is the real, unpredictable and sometimes frightening loss of capital resulting from volatility in financial markets. But so long as the investor maintains both the sufficient short-term reserves (cash and bonds) and discipline to ride out the storm giving the markets the opportunity to recover, it is temporary. Those who panic and succumb to the inevitable emotional pull to abandon the investment plan will convert the otherwise temporary loss into a permanent one.

Deep risk, on the other hand, describes the permanent loss of capital. The most relevant threat for long-term investors is inflation. Large positions in cash and even bonds which buffer investors from market risk expose them to deep risk. Even a relatively modest 3% annual inflation will destroy 50% of an investor’s purchasing power in just 25 years. That means it will require $100 in 2039 to buy the equivalent of $50 of groceries today.

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