Avoid Overpaying for Inflation Insurance

When buying insurance you want to avoid overpaying. When trying to insure against the risk of inflation investors buy Treasury Inflation Indexed Bonds (TIP’s), precious metals, commodities, EM stock, options on inflation sensitive investments, etc. They could overpay and end up losing money for an inflation that either did not occur or occurred so far in the future that the defenses degraded or cost too much before inflation came.

Currently 1-5 year TIP’s have a negative real rate. Gold mines in the boom of 2008 experienced a 25% annual increase in operating costs that were far higher than the CPI. Commodities may have had a one time boost due to China’s needs plus Chinese speculators in China who have few investment choices. If something goes wrong with China’s economy then the commodities 10 to 17 year secular cycle boom will end with a crash, except for oil. When buying a long position in commodity futures investors overpay due to contango. (Contango occurs when commodity futures markets charge higher prices for contracts in the future compared to “spot” market prices). When investors buy options they take a risk that the option will decay and expire worthless. So the point is that investing to protect from inflation is risky and one could overpay for insurance and loose money.

The studies about diversifying by adding commodities to a portfolio over 40 years had results, favorable to commodities, that were mostly attributable to a large one-time boom in agricultural commodities in the early-mid-1970’s. If someone bought commodities in the late 1970’s when inflation was at its worst they may have lost money and not protected themselves from inflation. Real estate investing in the 1970’s was profitable because people used fixed rate loans. Today rental properties are often bought with adjustable rate loans, so if inflation hits then mortgage loan interest rates will be very high and this will hurt buyers of real estate so they will not buy and then the price will go down or else not go up enough to compensate for inflation. Some of the worst investment losses were due to the crash of the 1970’s oil boom in 1982.

Even buying equities of non-commodity companies is not a one-for-one pass through for inflation. During inflation companies cut their margins to avoid losing market share and then earnings decline, hurting share prices.

So if you disagree with my deflationist views and want to load up on inflation hedges please careful because the best hedges are expensively priced and are not guaranteed to correlate with inflation. Tony Boeckh said in the book The Great Reflation that if commodity prices get too high then demand will be reduced making prices go back down. A basic principal of Graham and Dodd investing is to avoid overpaying for investments; buy only at a discount. So they would not buy inflation hedges today. The first rule of investing is to avoid losing money.

The one exception to my cautious view on inflation hedges would be oil because the theory of Peak Oil is probably correct, however using the concept of buying at a discount to have a margin of safety it is not now time to buy. Wait for a double dip recession to buy oil stocks.

About the author

Don Martin, CFP®

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