Two types of risk, two types of bubbles

Most investment advice is focused around managing risk. But what exactly is risk?

In an upcoming book, famed author William Bernstein separates the concept of risk into two categories. “Shallow risk” is the chance of a temporary fall in the price of an asset. “Deep risk” is the potential for a significant and permanent loss.

Charlie Munger once put this slightly differently: “Using volatility as a measure of risk is nuts” he said. That’s shallow risk. “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” That’s deep risk.

According to Bernstein, four things cause deep risk: Inflation, deflation, confiscation and devastation. I’d add another: Extreme valuation.

In the deep end

For markets as a whole, deep risk has presented itself only a few times in the last two decades: shares in 2000, US real estate in 2006, and (likely) precious metals in 2011. In each case, valuations were nearly double (or more) above historic norms. And in each case, it could be a decade or more before losses are recouped. This is very different from the market’s normal wiggles. You can ride out shallow risk. Deep risk leaves permanent scars.

The deep-versus-shallow risk comparison is a reminder that we often lump investing concepts into a single category when the reality is more nuanced.

There’s another investment concept that we mistakenly conflate all the time: bubbles.

There are two types of bubbles: profit bubbles, and valuation bubbles. They are entirely different.

Bubbles ain’t bubbles

A profit bubble is when a company’s valuation might look reasonable, but the way it’s making money is perverse and unsustainable. US bank stocks last decade are a perfect example. Citigroup (NYSE: C) looked like a decent investment in 2006. Twelve times earnings, two times book value, 18% return on equity, and a 4% dividend yield. Those are respectable numbers. But the way Citigroup was earning money — packaging and selling the most asinine mortgage loans ever created — was dangerous and unsustainable. That was the bubble.

A valuation bubble is the just the opposite. The company’s valuation gets crazy, but the way it’s making money is solid and sustainable. Wal-Mart (NYSE: WMT) is a good example. In 2000, Wal-Mart stock traded for more than 50 times earnings — astronomical for a retail stock. That sky-high valuation kept returns low over the following decade. But there was nothing wrong with Wal-Mart as a company. Business boomed from 2000 to 2010. Earnings per share grew threefold. Shareholders received almost $30 billion of dividends. Investors’ pain was entirely due to starting valuations. That was the bubble.

Foolish takeaway

Just like deep-versus-shallow risk, the difference between profit and valuation bubbles has to be appreciated. We talk about them as if they are a single topic when they can mean very different things and lead to very different outcomes. I’m all for keeping things simple, but as Einstein put it, “Everything should be made as simple as possible, but not simpler.”

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A version of this article, written by Morgan Housel, originally appeared on Morgan does not own shares in the companies mentioned.

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