Hedge Inflation Risk with Hard Assets

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Hedge Inflation Risk with Hard AssetsDiversifying your portfolio will help to lower your risk and increase your returns. One of the asset classes that we use to build diversified portfolios consists of hard asset stocks. These hard asset investments include companies that own and produce an underlying natural resource. Examples of these natural resources include oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel, and other resources such as diamonds, coal, lumber, and even water. We recommend broadly diversifying your hard asset stocks by resource type, by geographic location of a company’s reserves, and by company size.

Keep in mind that investing in hard asset stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities or their volatility. Whereas, buying a gold mining company is a hard asset stock investment.

Over time, dollars lose their buying power and the goods and services we buy cost more. Commodities, as an asset class, generally maintain their buying power in dollar terms. Stocks, as an asset class, generally appreciate over inflation after dividends are factored in. And, recently, hard asset stocks have been appreciating nicely.

Jeremy Siegel, author of the book “Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies” did an analysis of investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar’s worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 today. Because of inflation, a dollar today has only the buying power of about seven cents back then! However, the stock market, on average, has been appreciating about 6.5% over the long-term rate of inflation. Hard asset stocks give you the best of both worlds: the stability of a real asset plus higher market returns.

One index that tracks hard assets is the Goldman Sachs Natural Resources Index. This index is comprised of 70% energy and 11% materials. As of the end of April 2007, this index is up 9.36% year-to-date. Its three-year annualized return is 28.96% and its five-year annualized return is 19.17%

We segment hard asset stocks into their own asset class because they have a unique set of characteristics. First, the movement of hard asset stocks is generally less correlated with the movement of other asset classes such as bonds. Second, hard assets have a unique (and positive) reaction to inflationary pressures. And third, there are periods in the longer term economic cycle when including hard assets helps boost returns.

The beauty of hard asset stock is the fact that they are not highly correlated to US large cap stocks as a whole. The correlation between the Goldman Sachs Natural Resources Index and the S&P500 Index is only 0.38. Importantly, the correlation between the Goldman Sachs Natural Resources Index and the Lehman Aggregate Bond Index is even lower at -0.21. A negative correlation means that bonds and natural resources, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with hard asset stocks can help hedge the risk inflation poses to a bond portfolio.

Short and intermediate-term bond investments are usually stable investments – their value doesn’t fluctuate much from day-to-day and they pay recurring interest. The danger of having a large bond portfolio is that you will be exposed to greater inflation risk. Inflation causes the buying power of your fixed-income payments to decrease. If we have a period of high inflation like the 1970’s or a rapid devaluation of the dollar, a bond portfolio will lose a significant amount of its buying power to inflation even though its value may not have changed much in nominal dollar terms. In order to balance inflation risk, it’s important to include investments that provide a true inflation hedge.

Hard asset stocks provide an inflation hedge. Due to the underlying value of the tangible commodity that natural resource companies produce, their earnings are tied to inflation as their resources are worth more as the dollar declines in value. This can occur in times when the supply of money and credit is increased to fund government spending and budget deficits.

Consider a gold mining company whose expenses and overhead allow it to pull gold out of the ground for $290 per ounce and sell that gold for $300 per ounce making the company a $10 per ounce profit. As gold jumped 33% from $300 per ounce to $400 per ounce, the company’s profit jumped from $10 an ounce to $110 an ounce – a 1,000% jump in profit – which then caused the company’s earnings and stock price to soar. Now that gold is over $650 per ounce the current price level of gold stocks is much higher than it was in 2001.

During 2002, when the S&P 500 dropped over 20%, mutual funds that specialized in precious metal stocks (gold and silver miners) appreciated over 50%. Having an asset class that appreciates while other asset classes are falling helps both smooth and boost your investment returns over time.

Investing in commodity-rich foreign countries is also an investment in hard assets. The MSCI Canada Index has approximately 28.43% energy and 15.92% materials. This index has 0.80 correlation to the Goldman Sachs Natural Resources Index. Latin America (particularly Brazil), the emerging markets such as South Africa, and other developed countries like Austria and Australia are significant producers of natural resources and are strongly correlated to the global demand for commodities.

Because hard asset stocks are negatively correlated to bonds and other inflation-sensitive economic sectors, they provide a unique opportunity for diversification. Adding hard assets to your investments is not as simple as just increasing or decreasing their portfolio allocation to create a more aggressive or conservative mix. When a portfolio has very few bonds and mostly stocks, it needs less hard asset stocks to balance the inflation risk. When you are increasing bonds and decreasing stocks to make a portfolio more conservative, it helps to add more hard asset stocks to counter the bond risks.

Getting your hard asset allocation correct is made even more complicated by the recent changes in the volatility and historical correlation of all asset classes and sectors worldwide. The S&P 500 Index is currently comprised of 10.50% energy and 3.04% materials. If your portfolio contains any bonds, over-weighting this allocation to hard assets could boost your returns and decrease your volatility.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.