Tuesday, May 15, 2018

Just in case… Gold and other diversifying investments

When I talk diversification, I don’t mean Peter Lynch’s ‘Diworsification’: investing into so many different asset types that there is no net upside. In fact it often leads to losing focus and money.

I differentiate investments controlled by myself and those controlled by others. Gold held by me is quite different from gold held in an ETF that is controlled by someone else. In that case I am not even sure the gold they claim I own is actually there and not represented by a set of options that mimic the gold price. The latter is what makes it possible that each ounce of physical gold is owned by 5 owners with each owner thinking she owns the whole gold bar.  That is why derivatives are dangerous – in the end you may not own the ‘underlying’ but share it with multiple other ‘owners’. Options and futures are great for getting portfolio insurance as long as the other side (counter party) of the deal can actually pay you when required. Look what happened with AIG in the 2008 crisis?  How could Goldman Sachs or Bear Sterns be so levered up?  There was just air when it folded.

There are the doomsday prophets who believe that fiat currency is an empty promise and that the next credit crisis will be the end of the United States and the U.S. dollar as we know it. There is truth to that, but it is not a game of reality it is a game of trust. As Reinhart and Rogoff state in their book “This Time it is Different”, a country does not default until its population says that it had enough and they no longer want to carry the burden of excessive interest payments.  A currency does not default because it is a mirage build on a card-house of debt. It defaults when nobody has confidence in it and nobody wants to accept payment in that currency.  That is why I don’t see the ‘End of America’ in such stark and disastrous terms. Besides many other currencies are in much more dire straits than that of an over-indebted U.S.  Can the U.S. ever repay its private and state debts?  Probably not but neither can most other countries. This is not a license for politicians to print and tax without restraint. In the end, the interest payments will take away the means to act on real societal needs. This is even more important to consider in an rising interest setting.  It is the reason that high debt levels lead to ever more interest payments which in turn force a paralyzed government to tax more and do less, thus increasing inflation and the inflationary debt spiral.  We saw that in Canada in the 1990s and you-know-who is happily replaying this game in which his father so excelled.

So, yes you need to protect yourself against such shenanigans and invest in a currency that is not manipulated by the unwashed Deep State zombies such as gold. This is an important part of your diversification strategy.  If you hold fiat currency for the long term while always losing to inflation and  with negative after-tax returns, consider holding gold. It is not perfect but over the long run it appears to hold its purchasing power.  Crypto currencies may do the same, but they don’t have a 5000-year track record. In fact, cryptos have no track record at all.

Assets you control are best, the problem is not everyone is a good business person or speculator. Nor do we want to spend all our time on it.  Also, we’re dependent on the local economy where we typically hold those assets. So, no matter how much confidence you have in your local economy or other local economies, you need to bet also on other places. Look real estate in Calgary is kind of depressed right now and underperformed Toronto and Vancouver for years. Now with oil turning up that may change, and it may be Vancouver and Toronto that underperform. Prices there have fallen already 20% from their peak and some (there always people that extrapolate along a straight line) predict prices could fall by up to 40% from the peak.  I aim to have 50% of my net worth or more in assets that I control.

The rest is in paper securities – assets I don’t control managed by people that I don’t really trust. Heck, I don’t always trust myself because I know some of my less positive tendencies. Investing is a lot about self-knowledge never forget! So, we have 10 to 20% in gold and cash. We have another 40 to 60% in self-controlled assets and the rest 30 to 50% in assets not controlled by us – the paper portfolio.

My ratio of bonds versus stocks varies depending on the interest rate versus earnings yield ratio.  Today interest rates are low and corporate earnings/market capital (earnings yield or inverse P/E) is high, especially on an after inflation and after-tax basis).  Thus, I am very low on fixed or interest earning income.  Now that interest rates start to rise again, that may change. But never forget that no investment, GIC, government bond or gold is NOT risk free.  And risk is encountered mostly in two ways:  1: the investment goes broke – loss of all equity.  2: volatility – swings in market pricing. The first for example is the risk that somebody borrows money from you and doesn’t pay you back. 

The other – volatility is about keeping your cool.  See if the economy crashes and your portfolio value goes down with the markets then so will that of nearly everyone else. You may have been ‘the One-Eyed King in the Land of the Blind’ before the crash; you won’t lose your kingly investor skills and habits during that crash and you will remain relative wealthy compared to the rest.  Volatility is just about a fluctuating score card but the score cards of those around you are going down as well.  As long as you don’t panic and sell (and assuming risk number 1 doesn’t kick in) you won’t lose and your score card will go up with the recovering markets to ever higher highs. In fact, volatility is your friend because option premiums tend to go up with volatility and you can make profit on your ‘portfolio insurance’ or hedging strategies.  You can employ cash to buy assets on the cheap from those who panicked during the downturns or those who over-extended and were forced to sell In a down market. O… sweet profits!  You may not be able to time the market, but you can recognize the market trend and buy or sell accordingly.

We all make mistakes and we may have bought assets that we don’t control and that are handled by poor managers or that have poor business models. Thus, my 5% rule. Don’t invest more than 5% of your total PAPER portfolio value in a single paper investment.  That way, if you lose 25% (my theoretical trailing stop loss) your portfolio value should only fall by 25% of 5% or 1.25% of your paper portfolio value per bad investment. But, look at the word ‘theoretical’! First not all investments are created equal. Gold miners are a lot more volatile than say a bank. Don’t use the same stop loss.  Also, if the market falls by 25% do you sell your entire portfolio (probably at the very bottom of the market)?  No. So use these trailing stops with caution and always ask yourself: if you could buy that investment at those depressed prices would you buy it?  If you say ‘Yes’ then hold on, because if  you sell an investment with good upside that is not smart. But maybe you found another investment with even better upside and low risk, in that case you switch ‘horses’.  There is no real right or wrong here.  Also, selling may trigger a capital loss tax credit to be used against winners elsewhere..  You may want to sell your winners in order to rebalance your portfolio or…  or because its price is excessively expensive. In other words, at the current pricing  you would no longer want to buy such investment.  Then it is time to sell some or all of that past-winner. You can use the losses of a mistake to offset the taxable profits from selling the winner.

Now, a maximum holding value of 5% of your paper portfolio value does not mean you own only 20 stocks.  You may own multiple security types of one company and you thus should own a maximum of 5% in the various security types of that company.  Secondly, you never buy a full position in one fell swoop – you build it up over time. Typical you start buying small chunks 1 or 2% of paper portfolio value at a time.  You open with $5000 or $15000 depending on portfolio size or risk. Then you wait to see whether it works out. The initial investment may perform in many different ways and you may not be comfortable in buying more. Thus you end up owning often much less than 5% in that company.  On the other hand, you don’t want to spread out in too many holdings, with each holding thus small that it doesn’t impact your total portfolio performance. There comes a point the investment is too tiny and not worth the effort to hold. If you don’t see a catalyst for positive performance, it is better to ‘clean up’ your portfolio of small marginal holdings. In other words sell the small stuff – it only distracts. Thus, owning holdings in 30 or so companies is OK.

There you have it, a complete portfolio strategy in one blog post. As said, cash is in many forms – dollars under the matrass, in a bank’s savings account, a brokerage savings account, money market ETFs and gold. Gold is insurance against chaos and in the extreme case that you must leave an unstable country it is a universal currency. Gold is your “Just-in-case cash”.

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