Deep Risk – New Book from Bill Bernstein
August 30, 2013
Bill Bernstein, author of investment classics such as The Four Pillars of Investing, has released a new book called Deep Risk. In his own words:
Deep risk: How History informs Portfolio Design is the third installment in the investing for adults series. this series is not for novices. This booklet takes portfolio design beyond the familiar “black box” mean-variance framework. Most importantly, the short-term volatility of financial assets, commonly measured as standard deviation, is a highly imperfect measure of the actual long-horizon perils faced by real-world investors subject to the vagaries of financial and military history. These risks have names—inflation, deflation, confiscation, and devastation—and any useful discussion of portfolio design of necessity incorporates their probabilities, consequences, and costs of mitigation.
His book takes a look at portfolio construction with an eye towards history/market risk and how it can impact investors long-term. He calls it Deep Risk, and it’s an important topic to understand.
Bill allowed me to review a draft of the book and he has very insightful comments on portfolio construction that will be of interest to those that use the Permanent Portfolio strategy. In particular, he discusses economic cycles and how they impact portfolio performance and also encourages investors to consider extra-spreadsheet risks. These are both topics near and dear to my heart as a Permanent Portfolio advocate. I highly recommend his book.
Mebane Faber Compares Eight Portfolios
August 21, 2013
A recent blog post by Mebane Faber compares eight different asset allocation strategies. In his comparison, the Permanent Portfolio did not have the highest returns (it likely never will), but it had by far the lowest drawdown/volatility of them all (-12.7% compared to -30% or worse). So the Permanent Portfolio gave the smoothest ride to get those returns.
As we’ve covered before, I feel a portfolio with low volatility is very important for controlling investor emotions and ultimately achieving higher returns. A lot of investors get lulled into an investment strategy by promises of easy riches. But, when the losses start rolling in (as they can with any investment plan), many flee in panic and cause a lot of damage to their savings. The fleeing gets more pronounced the worse the losses are. In fact, many investors won’t even realize moderate low returns over time due to this behavior. I have seen repeatedly that market volatility is too much for most investors to handle and it must be carefully limited in an investment portfolio. Know thyself.
H/T – BP on the forum for pointing out this link.
Drawdowns and the Permanent Portfolio
August 15, 2013
Let’s talk portfolio drawdown and investing risk.
A drawdown in the sense of an investment portfolio is basically a loss it has experienced in the past. In particular, a lot of people are concerned with maximum drawdowns. This can give an investor a good idea about how an investment has done in the past so they can perform a gut check on themselves.
For instance, a maximum drawdown for a 100% stock portfolio has approached -90% during the Great Depression. So that means anyone investing in 100% U.S. stocks should be able to stare down the possibility of a near -90% decline in their investment. Then again you could be in post-communist revolution Russia where you had a 100% loss as everything was nationalized. So it can always be worse.
On the other side you have something like the Permanent Portfolio that so far has had a worst annual drawdown in the -4-6% range in 1981. Of course this does not cover the Great Depression, but overlapping market times have seen very big losses in a single year (like 2008′s -37% stock drop). Or multi-year losses like 1973-1974 that had stock losses of -18% and -27% respectively. The important point is that a -4-6% loss is a completely different world than -90%, or even the -37% stock losses of just a few years ago. Perspective matters. And from the perspective of the Permanent Portfolio, the diversification protects you against large drawdowns.
Investing is Time Dependent
In further terms of drawdowns, understand that investing is time dependent. For convenience and comparison, portfolios are usually shown with annual returns. Comparing January 1st – December 31st of each year is just easier than going from March 3rd – December 31st, or June 17th, etc. However the world does not run on a fiscal year and reset every January. So the issue to understand is that drawdowns are time dependent on when an investor begins a portfolio and when they invest more funds or withdraw them.
For instance, an investor starting a stock heavy portfolio in January 2008 before the big crash would have seen much worse drawdowns than one starting in January 2009 after the crash had mostly run its course. This is really important to remember when comparing notes between investment strategies and what other people have done. Take these two examples with January 2008 and January 2009 as the start dates:
Vanguard Total Stock Market from January 2008-August 2013
Vanguard Total Stock Market from January 2009-August 2013
Amazing what a difference a year makes, right?
Yet over time both investors had positive returns. Yes, the person with the January 2009 start date did better. But, even the investor that bought in before the crash recovered their losses. So this speaks to the idea that being patient can limit your drawdowns. But how patient can you be when you are watching your life savings evaporate in real-time?
Next, look at that -50% decline the investor in 2008 took as they passed through the gauntlet. That would be really tough to watch if you were heavily invested in stocks, unless you were comatose the entire time. Even then, I’m not convinced. And the 2009 investor immediately lost 25% of their money before the markets recovered. How many investors would sit by and lose 25% without thinking about how much worse it could get?
That’s the risk of taking a large drawdown as well. The markets may in fact recover, but an investor taking a large loss might not have the emotional or financial means to hang in and see what happens.
Being Diversified Usually Means Owning a Loser
How does this relate to a diversified asset allocation like the Permanent Portfolio? Basically, in a properly diversified portfolio there invariably is going to be one real stinker of an asset. Maybe you bought at the peak, near the peak, or during a decline. It doesn’t matter if it was stocks, bonds or gold (the three main culprits for the Permanent Portfolio). One of them is likely going to tank in the future, is in the process of tanking now, or maybe is about to rebound after everyone has already fled in panic. Then again, you will likely find you also have an asset that can do no wrong. Often the winning asset is clocking in double digit returns for years in a row offsetting the losers.
The problem is you don’t know which asset will win and which will lose going forward. This means you must own all the assets all the time in a diversified portfolio and not go in switching things around. You also want to own enough of an asset to benefit during a bull market, but not so much that you get badly burned if it turns around and bites you. That is the only way to be protected from market surprises that can cause large drawdowns.
Ride in the Eye of the Storm
To protect against risk of large drawdowns, the diversified investor also has to deal with a lot of social pressures. There will be commentators jumping up and down screaming about doom and gloom or some asset about to take off to low earth orbit. And if you look for these opinions, they will be found. It’s called confirmation bias. Humans seek out opinions that confirm their own beliefs. But here’s something important to understand:
If you have a well diversified portfolio, you likely own an asset that someone, somewhere, is going to hate at all times.
If everyone I talk to likes all the assets in my portfolio, then I’m going to be pretty nervous. If however I have to listen to lectures from people because I own stocks or bonds or gold or cash and why either stocks or bonds or gold or cash is a horrible investment, I feel better. That means I’m riding right in the eye of the storm. The market winds are all around me, but things are pretty calm where I am.
And ultimately that’s what’s going to protect you from big drawdowns in a portfolio. It’s not about picking winners and riding the current popular wave. It’s about holding a variety of assets that are in favor and out of favor at the same time. It’s also recognizing that limiting short-term drawdowns with strong diversification means better long-term performance.