Hedge against inflation with stocks, not hard assets

The first part was published on October 16

Because of the difficulties of buying, selling and holding collectibles, some — who aren’t buying hard assets as collector’s items — prefer to invest in commodities, such as oil and gold. With many of these hard assets, actually owning the commodity is too burdensome, so instead investors purchase futures contracts, which are paper claims that give you the right to buy a fixed quantity of the commodity at a predetermined price at a future date. These future contracts are traded on commodity exchanges abroad. Dabbling in commodity futures is a game for big-time investors, not you and me. And the fact that institutional investors play the game doesn’t mean it’s a game worth playing. Returns from trading commodity futures are often horrible, the pitfalls are too numerous to list and the costs involved are astounding, especially if you invest through a commodity fund. Don’t do it.

But there is one commodity that’s relatively inexpensive to trade and for which you don’t have to buy futures contracts, because there isn’t a huge storage problem. That, of course, is gold. Indeed, for many investors, gold is synonymous with the term “hard assets.” All you have to do is purchase a couple of one-ounce gold coins, such as the American Eagle, Krugerrand or Maple Leaf, pop them in a safe-deposit box that rents for maybe $30 a year and you are ready for Armageddon. Unfortunately, if Armageddon doesn’t get here soon you may be disappointed with your returns. While year-to-year results have varied enormously, over the long haul gold — as possibly the preeminent store of value — generates returns comparable to the inflation rate. Simply matching inflation, of course, is hardly a way to build wealth. You want to do better than that? You have to look elsewhere.
Many have. Real estate is a popular choice. If you own real estate, you can garner far better returns than you would with gold. Return  may take the form of rent or price appreciation,  buying raw land may work depending on how old you are. Buying and selling real estate is also far more involved than trading gold, as well as being far more expensive. Most experts argue that if you own your own home, you already have plenty of real estate exposure in our environment this may not be entirely correct.

So if you are not going to buy gold, real estate and collectibles, because of low returns or high trading costs, what are you going to buy? Many have pinned their hopes on securities that promise to behave like hard assets. You might, for instance, invest in the stocks of companies whose primary business is the production, extraction or sale of hard assets, such as-oil and gas corporations, commodity producers in aluminum and timber business and real-estate development companies that make money by buying and then renting out real estate. These seem like hard-asset investments, yet they offer the chance to earn returns that outpace inflation. There is a good reason, however, why these investments outpace inflation. They are not hard assets. They are stocks. And because they are stocks, they tend to behave like other stocks. Result? When the broad market tumbles, these stocks often aren’t spared.

The most effective long-term hedge against inflation isn’t hard assets. It’s stocks. Over the long haul, stocks are your best bet for earning healthy gains that handily beat back the twin threats of inflation and taxes. But stocks are erratic performers over the short run and will likely plunge if inflation starts to accelerate. What’s the best way to hedge this short-run risk? A lot of smart folks advocate the Noah’s Ark approach to diversification. Buy two of everything in the hope of getting the broadest possible diversification. Throw in bonds, cash, stocks, hard assets and  the kitchen sink. This isn’t quite as foolish as it sounds. When markets become unhinged, usually one or two sectors do surprisingly well. But it’s hard to predict which sectors those will be. History is a rotten guide. Markets constantly surprise. So why not toss a little gold and maybe a few real-estate investments into the mix, in the hope that, when everything else becomes unglued, at least one of these will stick? I think this is a messy, unreliable way to build a portfolio, especially when we have two financial assets that are almost certain to provide ballast for a portfolio at times of market turmoil. Which two assets? Cash investments and floating rate bonds.           (Continued next week)