Bill Bernstein author of Deep Risk, spoke to Christine Benz, director of personal finance at Morningstar. Here is an excerpt from the interview.
In your latest e-book, you talk about various types of risks, and you distinguish between what you call "deep risk" and "shallow risk." Can you differentiate between those two types of risk?
Bernstein: 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.
In the book, you call the four big causes of deep risk the "four horsemen." Let's take them one by one. You mentioned Japanese equity. So, let's start with the risk of deflation.
Bernstein: 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 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.
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: the Dutch guilder, the English pound, the American dollar, maybe the Canadian dollar and a couple of other smaller countries' currencies.
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.
If gold is not such a great inflation hedge, 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.
(This refers to the period of hyperinflation in the Weimar Republic, which is modern-day Germany. It is said that a wheelbarrow full of money would not even buy a newspaper or a loaf of bread.)
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.
Are there any specific subcategories of equities 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.
