Protecting Yourself from Stagflation

No, it is not good advice because it does not even consider the prices of stocks, bonds or precious metals. Following advice like this, you are guaranteed to overpay for stuff. Any advice on "portfolio asset allocation" that ignores prices, is bad advice.

The only near-risk-free way I know of doing this is using TIPS/I- bonds. It may not be the best way because your after-tax returns may end up trailing inflation slightly. Because of the way taxes are handled, TIPS should be bought in a tax-advantaged account (such as an IRA) and I-bonds with regular taxable money.

I have heard all kinds of things with respect to how to divide your assets such as:

- stocks, bonds;

- stocks, bonds, real-estate;

- stocks, bonds, real-estate, cash;

- stocks, bonds, real-estate, commodities;

- etc.

My personal view (and I don't consider myself an expert since I haven't been investing long enough) is that this doesn't always protect you. The reason is that the markets are manipulated. It's hard to trust company balance sheets nowadays, and many companies are going under which means defaults on bonds. As for real-estate, I don't think the mess is anywhere near over.

Anoop

A glaring omission of that advice is the absence of real estate, including home ownership. Don't be misled by the fact that the housing market is down at the present time along with the stock market. Owning one's home can be great protection and a significant portion of net worth. Another thing that should be looked at is your participation in various pension plans. For example, if you have company pensions, annuities, eligibility for Social Security, etc., a large portion of the value of these could fall under a category that also includes bonds. Instead of bonds, I would prefer to say "fixed-income investments", or maybe just a category called "cash." If I had a pension that will pay a fixed monthly income at retirement, I would not want to load up on bonds in addition. You should also pay attention to what proportion of your pension funds are in stocks. That 1/3, 1/3,1/3 division leaves too much unsnswered.

You are right that this doesn't always protect you. The error is expecting anything to always protect you. No combination of investments or non-investments can shield you from risk.

Thinking otherwise can lead to scam artists. One of the things that Madoff was peddling was a stable, unchanging 1% monthly return.

No. The reason is that, for any investment, you are being paid to assume risk. Even "risk-free" treasuries are paying you to assume the risk that your money won't be inflated down to toilet paper and the (very small) risk that the US government will default. For stocks, you are being paid to assume the risk that company will go belly up, among many other risks.

-- Doug

Bear in mind that the default rate as of only a couple of months ago was less than 3%. (Up from about 1% at the end of 2007).

And that's on *junk* bonds.

Defaults on investment grade bonds are considerably lower.

The risk, of course, is that your investment grade bond could be downgraded to junk and then from there, on towards the higher (still, only 3%) default rate of junk bonds.

The risks may be vastly worse in the financial sector where leverage was up to stupid levels (and the mark-to-market rule, which still doesn't get enough attention from all those looking to focus blame in this).

Of course, banks and other financial entities make up something like 40% of the investment grade corporate debt (all of which adds up to less than either the treasury or mortgage backed markets). But even so, bear in mind that the last ones to get hit in the various bank blowups are the bond holders. Common equity often gets wiped out, and sometimes even preferred does. But bear in mind that much of the government's bailout was in the form of preferred. The government stands to take losses before the regular bondholders. That's not a guarantee of any sort, but it certainly should be a factor to consider in assuming that these bonds are as risky as you seem to be implying.

Of course, long-term returns on bonds have paled in comparison to those of stocks, even taking the last few years into consideration. The trick is to try to capture some of that long-term return and find a way to lower the short-run volatility as you go. The way to do that is to diversify amongst asset classes which are not strongly correlated. During this crisis, correlations between stocks and (non-treasury) bonds has been pretty strong. They haven't always been as strong.

Bear in mind, too, that there are other risks in bonds - if inflation heats up, their prices drop. If there is little liquidity, the bid-ask spreads may be terrible. These both affect the current "value" of the bonds, though if held to maturity, (and in the absense of a default), you'd still get the yield you paid for when you purchased them.

Note that those were trailing default rates as of late

FWIW, I'm not sure I believe that junk bonds make sense in almost any portfolio. If you believe the companies are creditworthy, you can buy some of their stock (though perhaps it should only be a small amount). If you don't, then why take the risk - they are correllated highly with the stock but have a much more limited upside.

But, again, that's all about junk bonds.

Investment grade bonds have much better characteristics with respect to lowering portfolio volatility and risk/return. And, of course, "investment grade" really needs to be examined in more detail - treasuries vs. MBS vs. munis vs. corporates -- all of which have different behavior and may play different roles in a portfolio. The treasuries may be the best way to offset volatility in an equity portfolio since when equities tank, the flight to safety tends to widen spreads out, too. But the horse is well out of that barn now, with 10yr treasury rates of less barely more than 2% and 30yr rates below 3%...

Any financial asset is worth buying at some price, so I disagree on theoretical grounds. Since bonds are senior to stock in the capital structure, there are distressed companies where the bonds trading at $20 (on a face value of $100) are a good buy while the stock is effectively worthless.

Empirically, the 10 year annualized return through the end of the 2008 for the Vanguard High Yield Corporate fund (VWHEX) is a mediocre 1.92%, but that is much better than the corresponding -1.46% return of the (S&P) 500 Index fund (VFINX). The data is from the Vanguard site. Junk bonds can outperform stocks over long periods of time.

An error that you and some financial planners make is to regard investments that span a continuum as being in discrete categories. In reality, there is no bright red line demarcating investment grade and junk bonds, although formally bonds rated below BBB are typically considered junk. It is nonsense to say that BBB bonds as a class are worthwhile investments but BB bonds (the rung below) are not.

Note, of course, my weasel word: "almost".

There is a place for some non-correlated returns to be generated by the most highly skilled of active deep-value managers working with assets of distressed companies. But the number of folks I trust to do that, I can count on one hand. I certainly don't put most junk bond funds into this category.

So can cash, sometimes. Or a very simple balanced portfolio of equities and investment-grade bonds.

Heh. It makes my life easier to treat asset-class based funds that way, but believe me, I know very well the distinctions.

There's certainly potential for value in them. I just don't think that for most investors, especially smaller scale ones, that junk bonds, as an asset class, are worth much attention.

In fact, with home prices down sharply and credit difficult to obtain, this is a buyer's market. If you can purchase real estate now and be patient, you may be rewarded years from now.