A.I.M. Users Bulletin Board

[ls7550]

Hi K.

Consider the longer term cycles. During one phase valuations are relatively low, you can for instance buy into inflation bonds (TIPS/Index Linked Gilts) paying perhaps +3% real (above inflation rates). You can buy a inflation adjusted income in x years time for less money today. At other times it swings the other way around, as of present where it costs more money today than what is paid back in inflation adjusted terms in x years time.

Historically at times yields are kept low, states print money to buy bonds such that demand and prices rise, yields fall. Sustained and sooner or later inflation exceeds what 'cash' pays. Repeated over a handful of years and some serious losses can be endured, half or more lost in real terms. We're sort of entering that phase now, just the absence of inflation so far. Each of cash/bonds/stocks can all lose, at the same time, but typically to different magnitudes. Diversifying across all three better ensures that you're not heavily concentrated into the one that loses the most. Gold can do well when 'more meaningful' inflation does hit. When investors lose whether they're in stocks, bonds or cash then gold is a favoured asset and its popularity/demand can soar to levels where losses in the other assets are offset by the gains in gold. But at other times it swings the other way around - where gains in stocks/bonds can offset losses in gold.

Inflation bonds can also serve well. Endure losses but not as harsh. For instance recent 10 year inflation bonds (Index Linked Gilts in UK) are priced to around a -2.5% real yield, so it costs $12,500 now to buy $10,000 of income/return in 10 years time (inflation adjusted). Repeat that for all years 1 to 10 and £112K of present day money buys £10K/year inflation adjusted return. In effect a -11% loss, but where cash/bonds/stocks in contrast could all lose -50% or more relatively quickly (over a few years).

Stocks have a element of inbuilt defence, the average stock is around 1.5x leveraged, corporate bond debts tally to around half of stock book-value. Debts when interest rates are lower than inflation is a form of asset, where the debtor in effect sees the debt eroded by inflation. Home values can also do well, as a chunk of the housing market is backed by debt (mortgages) that similarly may be eroded by inflation - and when debt is a 'asset' demand rises.

Own a home, hold some stocks, some inflation bonds, some gold and you're downside loss prevention when real yields are negative is somewhat insured. During periods of positive real yields, house, stock, bonds and even cash deposits tend to do well, and inflation bonds are available at a 'discount'. Even defensive assets can do well across a broad period of positive real yields, whilst being more protective across a period of negative real yields.

Clive.