Oct 12, 201712:25 PMFinancial Perspectives
with Michael Dubis, CFP
Known vs. unknown and deep vs. shallow risks
(page 1 of 2)
Last month I wrote about pragmatic preparation around events like Harvey and/or Irma. I recommend reading it to get your mind around preparation for the events we have no or little control over.
Markets — risks vs. unknowns
In regard to markets today there are three real-time events that have occurred in the past two months that have risks and unknowns tied to them. There are reasons markets react differently than we expect.
Known risks are already priced into markets. The unknowns cannot be since we have no history by which to assess or “price” it. When the unknown becomes known is when you see major moves in the marketplace in order to adjust to a brand new known.
Volatility is the result of markets learning new information that was once not understood or fully known. Knowing the directions of those changes in advance can be difficult, if not impossible, to exploit.
Author and investment advisor William Bernstein refers to risks as deep and shallow. Shallow risks are risks that time will theoretically cure. For example, a bear market, a stock market pull back, or even events like the 2007–09 credit crisis. Diversified investments over long periods of time have historically recovered. This is primarily why he refers to investing as shallow, and why we say investing is a long-term decision, not a short one. If you have short-term needs, those funds should not be tied to long-term investments and vice versa.
Deep risks are risks that are generally not recoverable. Examples include war, devastation, inflation, deflation, and confiscation.
We have three real-time examples of both deep and shallow risks right in front of us today.
North Korea — war vs. rhetoric
Rhetoric is of little consequence other than for those who are glued to anxiety-inducing media influence. I recommend avoiding it.
War has history to it, and it is the winner that may benefit. I use that term “benefit” in the most skewed sense because war is never good; it is destructive and awful, and the benefits here are relative.
All war is different and this type of possible war — nuclear exchange — is a complete unknown. Markets cannot possibly accurately price this exposure because the markets literally have no idea what to do with an actual nuclear exchange. No matter how smart commentators may sound, they don’t know. That is what it means to be unknown. If a war of this magnitude actually happened, it would be devastating and unrecoverable to the people impacted beyond other long-lasting indirect impacts around the globe.
The markets currently are pricing in rhetoric, though. This is fortunate in that the markets generally are pretty smart to all known information. Let’s hope it stays that way.