Inflation, Deflation, Confiscation and Devastation
In his book “How History Informs Portfolio Design”, US financial advisor and historian William Bernstein offers an operational definition of risk. Risk is the size of real capital loss times the duration of real capital loss. Magnitude and duration of loss are both important.
This explanation allows Bernstein to identify two types of risk: shallow risk and deep risk. Shallow risk is the loss of capital which recovers within several years, while deep risk is the permanent loss of capital.
Looking at risk in this way is helpful as it becomes clear some investments carry a larger amount of shallow risk, but that the opposite is true with respect to deep risk.
With deep risk, the four big threats are:
- Severe and prolonged high inflation
- Prolonged deflation
In terms of the probabilities that each threat will manifest, inflation is high, confiscation is medium, and deflation and devastation are low.
Incidents of high and sustained inflation, such as that experienced in Germany after the First World War, or, more recently, in Zimbabwe, are well documented. There are plenty of articles about how deflation led to the “lost decade” in Japan – Japan’s Nikkei 225 stockmarket index took over 30 years to recover its 1st January 1990 value.
Whilst there is plenty of information about inflation and deflation, there is much less talk about confiscation and devastation.
Confiscation is actually a significant risk, and much greater than we may imagine. When I think about confiscation, I immediately think of the state taking over the ownership of private assets – think of the Russian Revolution. This type of confiscation doesn’t happen often, thankfully. But tax is a type of confiscation, albeit partial. Employees can’t prevent HMRC from confiscating part of their pay, for example. Inheritance tax is another obvious example of confiscation in the real world, as is the Lifetime Allowance for pensions. Not so long ago, politicians were floating the idea of a wealth tax, and this is a reality in France and Spain. So, whilst complete confiscation is less likely, partial confiscation through higher taxes shouldn’t be ignored. It’s for this reason that it’s important that financial advice takes account of taxes too.
The best example of devastation, which Bernstein gives, is of war. It’s awful to think that this has become a real risk for Ukrainians. Bernstein’s solution of making sure that you don’t just hold assets in your home country still provides protection, and it’s an important argument for international diversification.
What Bernstein’s work shows us is that we should worry much less about short-term falls in asset values. If we do want to worry, we should be worrying about the long-term effects of the four horsemen of deep risk, rather than short-term volatility.
This is pertinent today when we are thinking about the investment climate as inflation has been rising – Bernstein would tell us to pay more attention to the risk that inflation becomes severe and prolonged than to the recent falls in asset prices. It’s worth reminding ourselves that inflation is a measure of how fast prices are rising – so, if for example, prices stay at their current high levels for a year, but don’t increase from those levels, there will be no inflation. I’m not saying that inflation won’t become severe and prolonged; but I am saying that the risk of prolonged and severe inflation is the one we should be considering most in the current economic environment.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner