Inflation Insurance

Clearly, holding Treasury bonds reduced the risk of owning stocks. Deflation is an equity investor’s worst nightmare, and holding some long-term Treasury bonds helped mitigate the risk. However, equities and especially long-term Treasuries are extremely vulnerable to inflation. Inflationary periods often cause equities to trade at low valuations, and they make the fixed dollar payments offered by the Treasury less enticing. A stock and long-term bond portfolio would perform horribly in an inflationary environment.

The portfolio needs something that can skyrocket in inflationary time periods to make up for the losses that would be suffered from stocks and bonds. A prime candidate is gold. Gold is a very controversial asset, and the debate over its role in a portfolio can become very polarized. Some feel that it is merely an instrument for speculation, while others see it as a currency that becomes attractive when yields are not compensating you for inflationary risk.

Many long-term investors dismiss gold because it is a static asset. If you buy an ounce of gold today, it will still be an ounce of gold 100 years from now. Your gold bars won’t multiply in a vault, nor will they pay you any interest or dividends.

So, why own it?

When global investors are uncertain about the future, the first place they flock to is the safety of the US dollar, purchasing US Treasuries because the dollar is the world’s reserve currency. However, if investors feel inflationary risks are not fully compensated for in Treasury yields, they often turn to gold and bid up the price.

Unlike paper money which can be created at will, gold mining has physical limitations that make sudden production increases less likely. Investors know this and in times of high inflation gold’s value skyrockets in percentage increases well past the annual inflation rate as investors pile in. This volatility gives it a valuable role in a portfolio. If inflation unexpectedly spikes upward, the value of stocks and bonds could move sharply downward. In this scenario gold’s high volatility is a good thing from a risk management perspective because it has the potential to more than make up for the other losses. Real estate and inflation-protected bonds cannot provide enough volatility to offset losses in other parts of the portfolio; they can only protect themselves. Buying TIPS or real estate for inflation protection is like buying fire insurance for only one room in your house.

Industrial commodities offer considerable volatility, but they have some major drawbacks. Firstly, they are heavily dependent upon the economic cycle. Gold's currency-like attributes make it less dependent on a strong economy whereas the industrial commodities are more of a hybrid play on inflation expectations and economic growth.

The second drawback for industrial commodities is the mechanics of investing in them. Physically hoarding these commodities is impractical, leaving investors with the option of investing in futures contracts. Investing in futures is messy, and one can be right about a commodities price movement but still lose money because of contango or backwardation. Furthermore, the actively managed commodity funds have high annual fees and the index based funds can suffer from front running.

One cannot expect incredible returns from gold over a lifetime, but it can provide price movements that reduce the overall risk of a portfolio. It is a tool that protects you in a low growth environment where bond yields fail to make up for inflation. In this context, it is very important to understand that gold's volatility is a very useful feature because it might need to make up for losses felt in both stocks and bonds. Even though it is not a desirable asset class in isolation, holding it as part of a diversified portfolio can be very prudent.

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