Wealth Preservation through Diversification
The hard truth is that it is not easy to preserve wealth. If it were, the families who were wealthy 200 years ago would still be wealthy today—and generally, they are not. In the very harsh economic environment that is likely to prevail over the next ten years, it is likely that a great deal of wealth is going to be destroyed. The economic system is in crisis and government policy, rather than market fundamentals, will determine the direction of asset prices. If the government fails to borrow and spend enough, the economy will collapse into a deflationary spiral. If it borrows, prints, and spends too much, there will be very high rates of inflation.
Future
government policy simply cannot be foretold with any degrees of precision.
Active wealth managers will have to rapidly adjust their portfolios in response
to changes in policy. That will be no easy task, even for the experts. Those
unable to devote all their time and energy to deciphering the kaleidoscopic
changes in the politics and policies of Washington have the option of
constructing a broadly diversified investment portfolio that would ensure
significant wealth preservation regardless of whether the price level moves up
or down.
The following
are five components of a diversified portfolio:
1. Commodities generally
perform well in an inflationary environment and suffer in times of disinflation
or deflation. Gold and silver benefit most from quantitative easing, which
undermines public confidence in the national currency.
2. Stocks tend to rise
(1) in a healthy economic environment, (2) when central banks create money and
pump it into the financial markets (so long as they don’t cause too much inflation),
(3) when the government runs a budget surplus and crowds in the private sector,
and (4) when the trade deficit is larger than the budget deficit. The last two
will be explained below. Stocks tend to perform badly when inflation at the CPI
level exceeds 4 percent, in a weak economic environment, and, particularly,
during a severe period of debt deflation.
3. Bonds benefit from
disinflation or mild deflation and suffer when there is inflation. In the third
quarter of 2011, the yield on ten-year government bonds fell to a record low of
1.7 percent. The Fed played a role in pushing the yields down by printing money
and buying bonds. There was more to it than that, however. There was also a
private sector flight to safety into government bonds as a result of fears that
the Greek government would default on its debt, which would have resulted in a
systemic banking crisis. Furthermore, U.S. yields seemed to be declining for
the same reasons that Japanese bond yields had fallen after Japan’s economic
bubble popped: the lack of viable investment opportunities elsewhere in the
economy.
The yield on ten-year JGBs (Japanese government bonds) has fallen
below 1 percent. It is possible that U.S. government bond yields will as well.
However, the risk-reward tradeoff of investing in government bonds with such
low yields appears highly unfavorable, particularly given the risk that
inflation could easily move very much higher at some point during the next ten
years.
4. Rental property can
provide a relatively steady stream of income, although, as the experience of
the last 15 years demonstrates, the capital value of the property can fluctuate
widely. U.S. home prices have fallen by more than 30 percent on average since
the crisis began and they could fall further, even significantly further in the
case of a severe debt-deflation scenario. Even then, if well located, rental
properties would continue to generate rental income. In a worse-case scenario,
rents would fall significantly from current levels. If they do, however, most
other prices would also tend to be much lower, leaving the owner relatively
just as well off.
5. Financing rental properties with fixed-interest-rate debt adds a further element of portfolio
diversification. Borrowing at fixed interest rates provides a hedge against
inflation. Should inflation move higher, the rents would adjust upward, but the
debt owed would remain the same, which would effectively reduce the burden of
the debt. The risk, however, is that in a severe debt-deflation, rents would
fall so much that the rental income would be insufficient to service the
mortgage. A prudent loan-to-value ratio mitigates that danger.
Those are the
basic options: commodities (including gold and silver), stocks (preferably
stocks with a good dividend yield), bonds, rental property, and
fixed-interest-rate debt. In combination, they form a broadly diversified
portfolio capable of preserving a significant amount of wealth in practically
any conceivable economic environment.
During a period
of high rates of inflation, the value of the bonds and the stocks would fall,
but the price of the commodities would appreciate. Meanwhile, the rental
property would continue to generate cash flow and the inflation-adjusted burden
of debt would decline.
In case of
deflation, commodity prices would fall. Stock prices would also fall, but the
decline would be offset to some extent by dividend income. The value of the
bonds in the portfolio would rise. And the rental income would continue to generate
cash flow, although in lower amounts if rents adjust downward. Mortgage
payments would remain unchanged.