Investment Risk and Noise: A Different Take



The following is my take on investment risk and by extension, noise. My view on risk has been shaped by William Bernstein and I have "borrowed" his terms deep and shallow risk. It is an excerpt from my book, "Forget the Noise".

There is a belief that taking on more risk leads to the possibility of greater investment returns. defines risk as follows:

“The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk.”

Now, I am not going to be the first person to say that this belief is short-sighted and incorrectly defines risk. Risk has context, and to universally quantify risk using a simple measure (in this case, volatility and standard deviation) is misleading. There were some very clever academics that brought us Modern Portfolio Theory (MPT), which we have discussed briefly. I am going to tell you to ignore them. Yes, ignore them completely[1]. I understand that this may be a leap of faith, but you have come this far in the book, so I hope you will give me the chance to explain myself.

The best definition of risk I have seen was proposed by William Bernstein in his short e-book, Deep Risk: How History Informs Portfolio Design. He defines risk as being made up of two parts. These are:

  • shallow risk
  • deep risk

The first, shallow risk, is relatively unimportant and short-term in nature. This shallow risk is short-term fluctuations in the market and is the dreaded short-term market volatility. As the name suggests, there is no real substance to this risk. This statement comes with one caveat, though. In some cases, shallow risk can destroy a portfolio. The most common is when an increase in shallow risk can lead to the permanent loss of capital (i.e. your investment’s value goes to zero).

Shallow risk makes us do silly things. It clouds our judgement. It can send our minds on an emotional roller coaster. Since shallow risk is market volatility, the most common occurrence is when the markets pull back strongly and quickly. This causes many market participants to sell investments after panicking. Even worse, it can cause some investors to become forced sellers. If there one thing you do not want to be, it is a forced seller. Often investors who use some form of gearing or debt to buy investments are most susceptible to becoming forced sellers. I have often seen this in people who speculate in CFDs (Contracts for Difference). These are leveraged investments that track the performance of listed shares. Investment returns (both up and down) are magnified when gearing is introduced. For example, if the gearing ratio is 10 times, then a 1% movement in the underlying share can lead to a 10% change in the CFD position. This is very attractive when the share price increases but can be catastrophic if the share price decreases.

The scary thing is, I have seen people bet their life savings on one CFD linked to one company. This is like walking into a casino and choosing a random number on the roulette table and then betting everything you own. A more appropriate name is Contracts for Destruction.

The point of my digression into CFDs is that it is an example of where shallow risk can be fatal. Luckily, long-term investors can stomach shallow risk and they, in fact, welcome it. Long-term investors stay away from gearing and speculation. They are concerned rather with combatting deep risk.

Deep risk is when things can really go wrong, and if you are susceptible to them they can be permanent in nature. There are three types of deep risks[2]:

  • Loss from catastrophe
  • Loss of investment discipline
  • Permanent loss of capital

Loss from catastrophe

Here Bernstein talks about all the topics we like to spend as little time as possible discussing: death or disability. A large legal judgement against you can also lead to unforeseen losses. This risk is outside the scope of this book, but some proposed solutions are life, disability and/or liability insurance.

Loss of investment discipline

After a slight digression in the previous deep risk, we return to the investment world. Bernstein specifically states that this risk is caused by investors overestimating their actual risk tolerance, which leads to poor asset allocation decisions. Lack of investment discipline also leads to the abandonment of investment strategy or panic selling of investments after large market declines.

This book is about creating a long-term growing income stream. This requires a long-term allocation to growth assets (defined as assets which can grow their dividends at or ahead of inflation over long periods). This implies that you should not be chasing the latest fashionable investment strategies. Your asset allocation and investment strategy should not change dramatically over time. Asset allocation is not tactical, nor is it dynamic. This means that you should not be changing your asset allocation on an ad-hoc basis. You should choose a long-term asset allocation that remains relatively static.  We will cover asset allocation in more detail later. All that you need to know in order to succeed, is that you need discipline, and to be able to ignore temporary market declines and all the noise that accompanies them.

Permanent loss of capital

This deep risk is the most important. It is often misunderstood. Most understand it as that your investment should not decrease in nominal terms. Asset managers must do everything possible to avoid earning negative capital returns. This leads many asset managers to go in and out of cash (i.e. change their investment asset allocations), with dire consequences.

This risk is actually about real permanent loss of capital. Real means that capital and returns are adjusted by inflation. In my mind it is, firstly, that the capital value of a portfolio in inflation-adjusted terms decreases in value measured over a long period. There will be periods when a portfolio loses value in nominal terms. If you are invested in real growth assets, then this will be temporary. Secondly, and more importantly, a portfolio which is unable to grow its income in real terms (i.e. grow in excess of long-term inflation) will be subject to permanent losses of capital. This is because the income stream will be worth less and less over time on an inflation-adjusted basis. Investors will only be willing to pay less every year for the income stream as time passes.

Bernstein highlights various specific examples of the permanent loss of capital. The first is periods of severe and prolonged hyperinflation. Hyperinflation hurts both stocks and bonds. Bonds are especially at risk and many bond investors may be subject to total loss in times of hyperinflation. Many bonds have fixed coupon (or interest) payments. Hyperinflation erodes the purchasing power of coupons.   Examples of hyperinflation in modern history include the Weimar Republic (pre-World War I Germany), post-World War II Hungary and current-day Zimbabwe. I would continue to invest in stocks and real-estate in this sort of market as in the long term these securities will have to eventually adjust to prevailing market conditions. This is because these are the securities that ultimately create inflation as they sell goods and services of which the prices are increasing.

The next example is severe and prolonged deflation. This is possibly one of the few times it is negative for stocks and positive for bonds. Luckily the world would be a very strange place if there was widespread deflation, and examples of deflation are very rare. While in these sorts of conditions it would be advisable to hold bonds and cash, I prefer to follow the more likely scenario (i.e. a world with no widespread deflation) and continue to hold the majority of my investment portfolio in growth assets.

I also hold a somewhat controversial view with regards to deflation and real assets (i.e. shares and real estate). Relative to cash and bonds, I agree real assets will perform poorly in a prolonged deflationary environment. However, deflation means goods and services will cost less in the future. Even though my income from real assets would decrease in nominal terms, it should not decrease in real terms. So the result is not as good as non-growth assets, but my income stream is still hedged to the level of prices in the economy. Due to my belief that it is very difficult, if not impossible, to consistently time markets, I would much rather be invested in real assets whether we are in an inflationary or deflationary environment.

Thirdly, the risk of confiscation can rear its head. This is especially seen as a risk in non-developed markets. Bernstein uses examples such as Revolutionary Russia, Cuba and China. The solution would be to hold some foreign-domiciled assets and have a means of escape (here a dual citizenship has its perks). While I am not a fan of an offshore asset allocation for income-producing portfolios, I concede that for those who live in politically unstable countries, the use of an offshore portfolio[3] as an insurance policy could be the prudent thing to do. I will deal specifically with offshore assets later in this book.

Lastly, we could encounter devastation. According to Bernstein, devastation is usually due to geopolitical disaster such as war. An example is the Second World War. The solution is the same as confiscation, above. Obviously, an offshore foreign-domiciled portfolio would only work for local devastation. If we have a global nuclear war then all bets are off. Realistically, at this point the least of your worries will be your investment portfolio.

Hopefully, you can see that risk is much more complicated than standard deviation. Interestingly, shallow risks are understood by those who have a mathematics degree. I have lost count of the numerous volatility-based “risk” measures floating around the world today. Perhaps the complexity of them is their allure. They lull us into a false sense of security by satisfying our human desire to be able to measure everything.

Deep risks, on the other hand, can be understood by the man on the street. They are also more important. When building a portfolio, each deep risk needs to be carefully considered.


Before we end the chapter, I want to introduce risk’s cousin, noise. Noise causes us to behave irrationally. It preys on our biases. The financial press is full of noise. Yes, the press. You can’t live with them but you can’t live without them. Again, I will not be the first to highlight the damage the financial press causes. The Internet has certainly not helped matters. For all the good the Internet has done, it has been the worst thing for financial markets. Information (or rather “noise”) now travels at the speed of light, intoxicating its readers and convincing them to take action.

To protect yourself, you need a filter – a very good one. For some, this means not reading the financial press and not watching financial TV channels. Some (the lucky few) are still able to be consumers of the noise but possess the talent to ignore it.

Personally, I think I sit somewhere in the middle. I follow a little bit. I read one financial publication (The Economist) but tend not to watch any Bloomberg TV or CNBC. I don’t read the business newspapers either. I do, however, use certain web services which search product news and fundamental financial information on companies I am interested in (one of my filters for the noise). I also follow the SENS news service in South Africa, which publishes regulatory information, financial results and trading updates on South African listed companies.

The point is that you need to work out where you sit. If you suffer from FOMO (aka fear of missing out), then it may be best to shield yourself completely from the financial press. I would recommend erring on the side of doing more filtering out than less. We like to think we are immune to market fads and speculation, but the reality is that we fall victim to them more frequently than we think.

Noise makes you do stupid things. It makes you sell investments at the worst possible times. Noise is also comforting. We are always looking to find the causes of events or the reason for something happening.

I am the first to admit it is far easier to write the above than actually put it into to practice. I can guarantee you that at some point in your life, you are going to see an investment drop at least 20% from the price you paid for it. No matter what anyone says, this is a painful (but hopefully short-lived) experience. It is even more painful in magnitude than the corresponding amount of joy that we would experience if the investment doubled in value. Why is this the case? I put it down to my belief that we don’t like to lose and that we always expect to win – i.e. we believe that we make the best decisions. The academics call it loss aversion or prospect theory. defines it as follows:

“A theory that people value gains and losses differently and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.”[4]

Why am I telling you this? You need to devise the fail-proof filter I mentioned earlier. Here I am going to give you a list of steps that I refer to every time I start to get that sick-in-my-stomach “I can’t believe this is happening” feeling. You may find my list useful as-is, or you may want to add to it. The point is that you need something to refer to and prompt you to start thinking rationally again.

I ask myself the following questions:

  1. Is the sun going to rise tomorrow?
  2. Is it still better to have monetary assets than returning to the barter system?
  3. Are my investments’ earnings related to the level of prices in the world (e.g. inflation)?
  4. Do I have a diverse number of income streams so that I am not dependent on any one income stream? (i.e. do I own numerous companies in different industries?)
  5. Does my investment portfolio address all the other deep risks (i.e. risks other than inflation?)

If I can answer “Yes” to these five questions, then I carry on. No matter how many headlines I read about the dire state of the world and the unsustainability of this and that, I continue my investing strategy. You may argue that my list is too simple. This is intended. It is five questions I can ask myself quickly to check my state of mind.

Here are links to my book and Bernstein's book:






[1] Harry Markowitz, who invented Modern Portfolio Theory, (MPT) wrote a follow-up paper in 1991 that said that MPT was being misapplied to individual investors.

[2] Deep Risk: How History Informs Portfolio Design by William Bernstein

[3] By offshore portfolio I mean investing in assets that are domiciled outside of your home country. In my case, this is outside of South Africa.

[4] URL: Prospect Theory Definition | Investopedia [accessed February 2016]

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