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Deep risks to your portfolio

(MoneyWatch) Author and investing theorist William Bernstein has just come out with a brilliant new eBook that has helped reframe my whole view on risk. His eBook entitled "Deep Risk: How History Informs Portfolio Design" incorporates a copious amount of historic data to examine investing risk in ways seldom discussed.

Before getting into what deep risk is, Bernstein discusses shallow risk. Most of my columns are about shallow risk, which is the loss of real capital that recovers in several years. The two 50 percent stock plunges earlier this century are examples of shallow risk. Bernstein argues that investing adults who have correctly calibrated their risk tolerance can get through these periods without a permanent loss of capital. Shallow risk, however, can be devastating for investors who tend to react emotionally to market swings. Bernstein illustrates this devastation at the start of his book by introducing the reader to a foolish physician couple who swear off stocks after the 2008 plunge only to return after markets hit a new high.

Bernstein defines deep risk as the permanent loss of capital. He gives the example of such risk as the 95 percent loss German and Japanese bond holders suffered after World War II. The four types of deep risk are:

1. inflation

2. deflation

3. confiscation

4. devastation

Inflation is the most likely of all of the deep risks. Bernstein studied sixteen nations that had sustained inflation of greater than 7.5 percent annually between 1941and 1996, led by Brazil with 147.5 percent annual inflation between 1961 and1996. Inflation can be devastating to bonds and the best way to insure against high inflation is a global stock portfolio, commodity producing companies, gold, and TIPS. Bernstein told me that he was a bit surprised gold hasn't been a better hedge against inflation.

Deflation is much rarer than runaway inflation. Deflation occurred in the U.S. between 1926 and 1933 when the CPI declined by a total of 29.8 percent. Stocks performed horribly, losing 83.4 percent of their real value between September 1929 and June 1932. Bernstein, however, defines this as shallow risk as stocks did quickly recover. The best way to insure against deflation is by owning Treasuries and even global equities.

Confiscation refers to the government seizing assets. Examples of confiscation include Argentina, Russia, China, and Cuba. Bernstein makes the point that taxes could also be considered confiscation, though he considers taxes as paying dues to a club with a billion person waiting list. Bernstein views the risk of confiscation to be relatively low in developed countries but much higher in others, where we may have some of our investments. Suggested ways to protect against confiscation are to keep assets in other countries, such as stashing gold inside a safe in Switzerland or owning a villa in France.

Devastation is the last of the four types of deep risk. Devastation can be human made, such as a war or nuclear plant contamination, or can be a natural disaster. If the natural disaster is of a global scale, there is little investors can do to protect themselves from financial ruin. Foreign held assets, however, can protect against local disasters.

Bernstein told me one could argue with his assessments of the likelihood of each of these deep risks occurring in the future and the cost of insuring against these risks. He said his goal was to lay out a framework to think about these risks. Mission accomplished.

I personally took comfort from Bernstein's book, as the solution seems to be right up my philosophical alley -- own a globally diversified stock portfolio, high quality fixed income bonds and TIPS, with a little bit of precious metals and mining stocks. I'm not planning on squirreling away any gold in a foreign safe or buying any foreign real estate, so I hope Bernstein is correct in his assessment that, here in the U.S., the risk of confiscation and devastation is low.

Bernstein's eBook is a fascinating journey through global financial history with some key lessons on portfolio design.

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