Deep Risk Or Shallow Risk: Should Investors Choose Stocks Or Bonds?

This week the Dow Jones Industrial Average (DIA) hit a new all-time high, closing above 16,000 for the first time. At these prices, a valid question is whether stocks are riskier than cash or bonds. The answer to this question depends largely on how an investor identifies risk.

Shallow Risk

Shallow risk can most simply be defined as a short-term drop in an asset's market price. If you are invested in the stock market there will be inevitable times during which the market will pullback, perhaps by nearly half. Shallow risk is as inevitable as the weather, but unfortunately forecasting short-term market movement is nearly impossible.

Deep Risk

Deep risk can be defined as a force that conspires to do long-term and unrecoverable damage to the purchasing power of a portfolio. There are multiple forms of deep risk, however, the best example is inflation.

Imagine, for example, that the majority of your assets are denominated in bonds (BND). You would have little risk of a short-term drop in prices, but huge risk over the long-term to inflationary forces.

As a result, investors overweight in stocks face enormous shallow risk, but limited deep risk. Investors in bonds face the exact opposite proposition. Figure 1 describes this in visual terms: with the Dow Jones Industrial Average in blue, the rate of Inflation in orange and the 10-Year Treasury Rate in red. Imagine that you were to put your entire portfolio in a fund denominated in bonds. The shallow risk would be very low; however, after inflation the investor only is rewarded by a single percent in excess of core inflation per year.

Alternatively, an investor may choose stocks. The line in blue has achieved remarkable returns this year, but may subject its owner to frightening drops in price (as was the case during the 2008 bear market).

Figure 1: Dow Jones Industrial Average Versus the U.S. Core Inflation Rate and the Ten-Year Treasury Rate (click to enlarge)

Conclusion

The logical conclusion to shallow and deep risk is as follows: Take shallow risk with money that is required to live in the short-term. Take deep risk with money that is required for the longer-term.

Personally I recommend that money that is required in the next five years be left out of the market. Then invest money for the long-term to take advantage of the compounding generated by equities. If short-term drops occur they simply serve as better times to invest through dollar cost averaging.

Even though the market has run up a good deal many individual stocks are still highly attractive. Some examples of desirably priced stocks are: AFLAC (AFL), Discover Financial Services (DFS), International Business Machines (IBM), Precision Castparts (PCP) and Union Pacific Corporation (UNP). A wise investor may choose to be thankful that desirably priced stocks are available and invest themselves accordingly.

Source: Deep Risk Or Shallow Risk: Should Investors Choose Stocks Or Bonds?

Disclosure: I am long AFL, DFS, IBM, PCP, UNP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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