Over the weekend, I received a great comment from one of my readers regarding ways in which an individual might implement various strategies for inflation protection and overall hedging against market uncertainty.  I’ve posted the comment below:

“Taleb recommends cash inflation protected securities for the 90% conservative allocation of your portfolio. Given the state of the US gov't, I would not buy TIPS, so other gov't issued inflation protected bonds would be a better option if you can handle F/X risk. Having said that, the risk to this is that nominal rates can rise without a corresponding rise in inflation due to purchasers of debt demanding a higher risk premium even if their inflation expectations remain the same. I think, given how Taleb indicates that you simply can't predict and only uncertainty is a sure thing, the best way to invest is to have a bit of everything: gold, dividend paying stocks, nominal bonds (gov't/corp), cash, options, and real return bonds. This way, you're covered against deflation, recession, hyperinflation/moderate inflation, and who knows, dare I say in case of prosperity, stocks.” 

(Before going any further, allow me to thank the individual who submitted this comment.  [I default to anonymity but if you’d like to be identified in future posts please let me know.]  I truly enjoy interacting with readers and sharing ideas and thoughts on the economy and the markets.) 

I want to take a few moments to look closely at some of the items in the above comment and share my thoughts on them. 

It’s true Nassim Taleb (author of “The Black Swan”) recommends a “barbell” approach for most investors when allocating their capital.  What this equates to is putting 80-90% of your funds into very conservative instruments, such as cash, and the other 10-20% into very high risk instruments like options, where payoffs are significant if your options come into the money.  This way, you’re insulated against catastrophic loss but positioned to strike it big if your options hit.  (Options have the potential for cubic payoffs, a concept I’ll examine in greater detail in future posts.) 

But the commenter brings up a good point – what about inflation?  While we’re currently facing a deflationary environment as trillions of dollars of wealth continue to disappear off balance sheets in the form of foreclosures and other loan defaults, high inflation remains a good possibility down the road, not only because of the government’s penchant for creating stimulus in the near term, but more so because we’re short about $50 trillion in entitlement funding and have nowhere to get it aside from printing it (and it’s unlikely we’ll be able to borrow any significant fraction of it either).  Printing all of these dollars would vastly expand the money supply and hence cause inflation.

I agree wholeheartedly that TIPS, or Treasury Inflation Protected Securities, are an ineffective hedge.  These instruments are designed to keep pace with inflation each year, but that adjustment factor keys off of the government’s inflation figures.  These figures leave out critical data points, like food and energy costs, and often include substitutions when convenient.  The best example of that was when housing prices soared in the mid-2000’s, and the government replaced those price points with rents (which were falling), thus making inflation seem lower than it actually was.

Investing in foreign governments’ bonds can protect you against inflation simply because, from a foreign exchange (or FOREX, or F/X) standpoint, you’d be invested in a currency opposite to the dollar.  So if the dollar weakened significantly due to inflation, then other currencies would strengthen commensurately, thus adding an element of protection to your investment. 

But there’s a catch, as the comment points out.  If you buy those foreign bonds, regardless of inflation expectations, other investors may begin to look for higher yields to cover the risk of investing in those bonds, and the resultant rising yields will mean falling bond prices, thus devaluing your investment.  (Think of the seesaw analogy for bond prices and yields.) 

So there’s no perfect place to put your money, which you’ve probably already figured out a while ago.  As the comment says, Taleb states that uncertainty is one of the few things you can count on as a given.  Therefore, ideally you would try to cover every base and invest in everything from metals like gold and silver, to stocks, bonds and options.  While I agree in theory here, this is simply not a realistic approach for 90% of middle class investors due to capital constraints.  However, it’s not unrealistic to suggest that one might build up to this kind of portfolio allocation by adding components to it over time.  

Personally, I wouldn’t take this approach in its entirety as it could potentially dilute overall returns.  Right now I favor cash and equivalents for most of my position, with options, short Exchange Traded Funds (ETFs), and precious metals rounding things out.  I do have some dividend paying stock in foreign markets invested through Euro Pacific Capital, and plan to add more to these positions over time.  However, I don’t have much of an appetite for US stocks due to the macroeconomic outlook here.  The commenter made a nod to this fact as well when stating that “in case of prosperity” stocks might be a good investment.  Clearly, he and I share the same trepidation about the domestic markets.

I do plan to get into more specifics on hedging strategies and options investing, and will attempt to offer some ideas on relating these approaches to your individual portfolios.
 


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