Evaluating Risk: Why I Sleep Better With 50% Of My Money In Precious Metals

| About: SPDR Gold (GLD)

This article is not to suggest you invest in any particular way, but is written to provide readers with a different frame of reference - and to suggest a flexibility in thinking - in a fashion that personally fits the individual reader, to assess risk.

What kind of investor are you? What is your risk profile?

Recently, I was asked these questions for a survey by a management consultant for a top 10 brokerage house. Their client wanted to learn how to do a better job keeping and getting more customer accounts. Moreover, to find out what I would want from a stock broker in terms of service, they wanted to first assess how I felt about risk.

The truth is, I don't like risk. I'm a fairly frightened investor these days.

Yet, the risk profile of my investments by the judgment of the majority says I am a high-risk aggressive investor.

About That Question

My answer to the management consultant's question was defensive. "I don't know how to answer your question. I think precious metals are low risk and bonds are high risk right now. That doesn't fit..."

To summarize, if I'm ranking my investments from low to high risk, I currently rank asset classes this way: precious metals (lowest risk), frontier and emerging markets, U.S. and European equities, cash, bonds (highest risk). I am almost completely backwards from everything post-World War II investing has taught us.

By my judgment of risk, I'm invested conservatively with targets of 50% precious metals, 20% to 25% in frontier and emerging markets, 20% to 25% in other global markets (U.S., Europe and other), and a remainder in cash looking for a home like an alert puppy.

In the classical judgment of risk since World War II, I am an aggressive high risk investor.

Identity Crises May Be Brought On By Economic Crises

I feel like I've been grumpy for over a decade. Back in 1999 I grumbled that technology couldn't keep going up forever, and to make the point clear I said to whoever would listen dead-pan in late 1999 and into 2000, "Cisco (NASDAQ:CSCO) is going to 8." It was just a random number I picked flakily looking at a chart. A friend I tried to advise with pithy comments like this lost half her money when the tech bubble finally burst. Then, she was angry at me I did not make my point clearly enough. Later, she inquired about whether I bought Cisco (CSCO) when it went down to almost $8. (I did not ever purchase Cisco despite the intraday low of $8.12 on 10/8/2002. I'm not someone who has ever made any useful money shorting.)

Source: Yahoo! Finance.

It Can't Go Down, Until It Does

2003, 2004, 2005, 2006, 2007. Year after year people told me: "You have to buy a house, real estate prices never go down." I did not. Real estate prices went down.

I bought a foreclosure property in 2011 - the first property I have owned - and I still fear I was way too early into the housing market. However, my wife and I arrived at the moment when it was time for us to buy a house, and then we found a house we felt we could keep for 30 years or more. In 30 years, the value of the home should go up, but if it is lower in value during the first 5 years, I will not be shocked. Real estate is risky these days. As real estate risk varies widely by location, it is not categorized on the above list of low to high risk.

After A House Burns Down Is The Time It Is Cheapest To Insure

Risk is often lowest at the moment when people are all shout that it is a high risk. My friends and family worried for me when I took a flight a couple of weeks after 9/11. I figured the safest days to fly were immediately after 9/11. The airports were nearly empty and security was on high alert.

Source: Yahoo! Finance.

By the same token, when I worked at a bank in a department servicing high net worth individuals, we had a client who had stocks dating as far back as 1932. 1932 was a pretty good year to invest as it turned out, but at the time most people would say it was high risk after what had happened the prior 3 years.

My Hot Tip Guy

There's a financial professional in my life who is not someone I invest with. I hope he's not reading this as I rely on his calls now for market signals. He calls me with great ideas at their tail end, when he's found portfolio managers that have done well with an idea over several years.

We'll call him Kent. Kent's track record is perfect so far. He's called me with a natural gas idea when natural gas was over $10. His natural gas idea "couldn't miss" unless natural gas went below $4 (it did, and it has gone below $2.25 now). Kent called me with a brilliant stock portfolio idea early in 2008: the guys managing this portfolio were, according to Kent, "really good" (I think we know what happened later in 2008).

Most recently Kent called me and told me he had these portfolio mangers making a killing investing in bonds. So, there I am sitting on the other end of the phone as Kent pitches these bond portfolio managers thinking: oh no, bond markets are going to collapse soon. Ugh, time to look at shorting bonds with (NYSEARCA:PST), (NYSEARCA:TBF), (NYSEARCA:TBT), (NYSEARCA:TMV) and their like.

This cow did not invest with Kent and now owns a large piece of beachfront property. Source: Author's photo. County Donegal, Ireland.

Kent is usually within one year of whatever long idea he is calling me about collapsing. Using the Kent metric, the U.S. bond market has until the end of August 2012 at best. Not very scientific, but he has a good track record, and the point of this is: I worry.

I Worry, Therefore I Invest

If I thought cash was a safe investment, I would probably be 100% in cash. However, unlike the folks who work in Washington, D.C., I do my own shopping. I see the prices of things going up and I really don't care what story government statistics and politicians are trying to sell me. I know how much the cost of living is going up as I feel my pocket get lighter and see my supermarket shopping bill get bigger; not to mention the net weight of the packages of food that now cost more getting lighter too.

Yet, I hear the arguments about deflation versus inflation. I understand. I have listened to both sides and an important conclusion I have reached is that my investing reaction to both deflation and inflation is the same. Thus, it is moot, I only need to know I'm a "flationist."

Source: Frankrod Hubpages, inflation and deflation basics.

My reaction to my "flationist" philosophy is two-fold:
1) I want to protect what I have.
2) I want to protect the buying power of what I have which likely means I need more than what I have (i.e. go make money in the markets to get ahead of the 'flation).

Further to that point, the below listed items are "a store of value" which means their value holds whichever way the 'flation goes. Thus, there will be no internal debates for me here about how: home prices are falling; while food prices are going up; while the government doesn't count energy prices toward inflation because they're not correlated; while the price of computer and television technology comes down as it gets more mature; while clothing prices are going down; while clothing quality and durability also goes down which actually means clothing costs go up more long-term, though go down near-term.

I will leave it to others to harangue over deflation vs. inflation. I just know the value of what I own is being dislocated by global economic problems. My job is to protect myself against that dislocation regardless of the name this economic period is given by economists and historians, and I should be prepared for all the outcomes and namings possible.

Precious Metals, Shiny Objects That Drive Me Nuts

I started investing in gold around $440/oz. My initial investment was 10% of my total investments. I had spent the prior two years bandying about with a friend (who worked at the Federal Reserve) and my stock broker that investing in precious metals made no sense (call it my "Warren Buffett phase" of precious metals investing - see page 18).

As I read more, precious metals started to make a little sense. The principal of investing in something that has been an historic monetary unit for thousands of years during a time when global currencies that are backed by a faith more suited to the most cultish of religions started to ring a bell with me.

Source: Dreamstime.com.

My theory was that if this whole nutty theory that precious metals were going to make a comeback was true, I needed to invest a decent chunk of money into them to actually insure the rest of my portfolio. 10% seemed good enough initially. I wasn't that scared and I didn't believe in the precious metals thesis too much back then.

Fast forward to today, and my precious metals positions have bubbled to over 50% of my portfolio whlie precious metals prices are up about 4 times from the time I started investing in them. The more concerned I have become, the more precious metals have gone up, the more I have bought. I hate it. I don't want to be in precious metals at all. However, I have seen what our politicians and central banks do. So far, from both left and right, their solutions to our current problems seems to be: do more of what got us here.

Broken Point

My breaking point was the 2008 crisis when I rolled what was left of my bond portfolio into precious metals between October 2008 and February 2009. With the income generation of bonds decimated and the government response to the crisis of bailing out the financial institutions, I was cornered into rethinking risk. I concluded financial institutions being bailed out meant they would learn nothing, and that meant the government bail outs would ultimately create more systemic risk.

I have never been to a casino where if I, or you, lose half of my or your money, the house just gives us more money. However, that's the world our too-big-to-fail financial institutions live in. If they make money, they keep it and get big bonuses. If they lose money, they get a reset and more money to keep the system going.

The capitalism I learned about in school does not have a reset button. It is supposed to have consequences that badly-run-businesses fail, well-run-businesses succeed. There is supposed to be a cycle of increasing risk-taking when the economy does well that is counterbalanced by those who take on too much risk failing when the economy slows. Failure to learn the basics of the business cycle (that economies go both up and down) is supposed to be punished by failure from which others learn and surviving well-run businesses profit.

You can purchase this at Despair.com in the form of a poster, T-shirt, or mug. I was not paid to promote this poster and will get nothing from it, I just love the succinct clarity.

Sure, You Could Trust Cash And Bonds

Sitting in cash and bonds is historically safe. Bonds have performed fantastically in the recent years - in fact, U.S. Treasury bonds have had an historic run. U.S. Treasuries, an investment position that is historically conservative, has created equity-like gains while producing the lowest amount of income they have in over 50 years. Other people I follow who have large positions in precious metals consistently recommend U.S. Treasury investments to those seeking a safe place to hold their money. These experts do that because their recommendation for precious metals is a conservative recommendation, thus they recommend a traditionally conservative hideout for funds not in the precious metals market that will at least generate a small return on cash.

Beyond Trust

However, I am past trusting the folks in government and central banks to care about the economy I live in, or to care about the other economies around the world (such as Greece or Japan) that effect the financial world I live in. I say this without political agenda, except a small hope that the Tea Party and Occupy Wall Street groups will find common ground to unite upon. These two groups are two sides of the same coin and have more in common than they have different: they share frustration at the ineptitude of people in power to work toward solutions meaningfully. The same frustration and sign of the times is why Republicans, Democrats and members of the media formed NoLabels.

I do not belong to, or support directly any of these groups. I just worry, like they do, that we're too far gone down the wrong path.

The "flationist" in me figures regardless of how that wrong path turns out, precious metals will have their day once again as a store of value. I'm still not that keen on gold and silver, but as things continue to unwind in Europe, the U.S. and Japan, I don't see where else people's worries can take them in the long run. Maybe the hedge fund guys have some other fancy ways to make money from this scenario that will work well for them, but for the rest of us, the shiny stuff is the most accessible safe insurance policy against another wave of global economic turbulence.

It always happens right as the movie is ending when you really have to "go" doesn't it? Times that require buckling up are not convenient. Source: fearoflyinghelp.com

If your currency starts 'flating too much in either direction, are bonds paying interest rates below 5% really going to keep up with the 'flation? In an investment world that has events likely coming that will force more de-leveraging, how can we expect stock markets to go up when that de-leveraging causes liquidity to exit the markets and then domino as one institution de-leveraging and tanking a market in an isolated area a little bit will cause another and another and another to de-leverage?

This is why the central banks of the world bailed out all the banks and financial-related institutions in 2008: the central bankers feared the de-leveraging domino effect would cause collapse and chaos. However, their solution of providing liquidity had elongated the timeline of the problem - see European dominoes below for an example of possible outcomes, and notice the 25 to 1 leverage casually referenced.

The real hope against a wave of de-leveraging is that the central banks of the world continue to unite to flood the world with more liquidity, what one could call an easy currency policy. Easy money is too opaque a term in the same vein as quantitative easing. Let's be clear, the central banks of the world add currency into the system out of thin air, and then the banks add more currency into the system by leveraging the currency created out of thin air from the central banks. When you hear a bank is leveraged a mere 3 times, just think of it as a bank taking a swath of thin air (an electronic version of a thin slice from a tree imprinted with colors, i.e. electronic paper money) and then gambling with three times that human-invented faith-based currency.

Further explanation of this system may hurt your head. Leverage is great when it makes money. But try spending a week with the Wall Street Journal circling every time the word "leverage" is used and then try to imagine what happens if all that leverage (which is really non-existent gambled money) is sucked out of the global financial system. If you went to Las Vegas with your only $1,000 saved, then gambled $3,000 because you felt lucky, and then lost only half of that $3,000, you'd be short $500 and in the beginnings of trouble, wouldn't you? Now change those thousands to the trillions in the financial system and one can see the trouble brewing.

Hate It

To be clear, I hate my big holdings in Gold (NYSEARCA:GLD), Silver (NYSEARCA:SLV) and the 50/50 closed-end Gold/Silver Central Fund of Canada (NYSEMKT:CEF). I am tired of investing speculatively in a host of precious metals miners and exploration companies. I want it all to go away. I want to invest in a time where it is easy to invest normally and do well like my former client's holdings from 1932. But, we're not there yet, and it is my precious metals that make me feel safe.

When Kent calls me about a great precious metals fund he's investing in, trust me: I'm selling.

Don't Believe Me

As Kyle Bass aptly put our current situation in a recent newsletter:

Imagine a team of mountain climbers all strapped together for safety as they ascend a treacherous peak. While they are all holding onto the mountain there is no additional strain placed on each other. Now consider what happens if one climber, let's call him Stavros, slips and loses his grip. He places added strain on the remaining climbers. One climber might not make a difference, but as Seamus, Pablo, and Jose each lose their grip they not only add extra total dead weight to the team but also increase the amount each other climber has to carry, until finally, Francois, Luigi and Takehiro let go and poor Jurgen, and Uncle Sam are left trying to keep the whole team on the mountain. (page 7)

For those keeping score, Stavros = Greece, Seamus = Ireland, Pablo = Portugal, Jose = Spain, Francois = France, Luigi = Italy, Takehiro = Japan, Jurgen = Germany, and Uncle Sam = the U.S.

This climber might be a metaphor for Greece or Spain or Japan, but if the other central bankers don't hang on to him, there is fear they will follow him down. Source: The Guardian.

This doesn't even include the ties that bind the U.S. and Japan with Europe.

Yet, Mr. Bass is one of those hedge fund guys that made a killing in 2008 and requires a minimum $5 million investment which means he's good, but probably out of our price range. So lets instead rely on the evaluation of a central banker that is one of many Goldman Sachs (NYSE:GS) alumni in government positions worldwide.

This Carney Has No Carnival Tricks Up His Sleeves

I am of course speaking of the Goldman Sachs alumni with incredible integrity from Canada, Mr. Mark Carney, Governor of the Bank of Canada. Mr. Carney's speech and graphs from December 12, 2011, are honest and scary. As I have mentioned, I'm an easily frightened investor, but I think a perusal of Mr. Carney's work will not aid anyone in global economic optimism.

These next three charts are from Mr. Carney's speech.

U.S. debt to GDP ratio is at its highest since the Great Depression. Does it matter?

The U.S. recovery from the current recession is the worst on record since the Great Depression. My question when I look at this chart: has the U.S. recovered? Or, are the dynamics of today simply making the bottoming out process take longer than in prior times? On the bright side, our recoverey has to be quicker than Japan's from their 1989 fall (still in progress).

Across the Atlantic Ocean from the U.S., the European continent is also experiencing an historically weak recovery. Again, one could ask if the recovery is this weak, is it actually recovery yet? or are these countries still in the process of finding their bottom to recover from?

Here's Mr. Carney's sobering opening salvo to the speech where these charts were presented:

Most fundamentally, current events mark a rupture. Advanced economies have steadily increased leverage for decades. That era is now decisively over. The direction may be clear, but the magnitude and abruptness of the process are not. It could be long and orderly or it could be sharp and chaotic. How we manage it will do much to determine our relative prosperity.

I cannot recommend highly enough reading the entirety of Mr. Carney's speech.

Back to Bass-ics, Kyle Bass-ics

Returning to Mr. Bass, he likes to talk about the compound annual growth rate (or CAGR) of global debt.

Following this chart from Mr. Bass, he notes:

[T]he total credit market debt is 310% of [global] GDP. We are saddled with the largest accumulation of peacetime debts [in history] without any playbook for what happens next. Throughout history, whenever total credit market debt breached 200% of GDP, it was commonly due to deficient spending fueled by borrowing as nations prepared for and then fought wars. To the victor went the spoils (and debt pay-downs) and to the loser went defeat and default. Given the enormity of the debt burdens of the PIIIGSBF (Portugal, Italy, Ireland, Iceland, Greece, Spain, Belgium, and France) coupled with those of Japan (and at some point the US), lending schemes designed to lend more into an intractable debt problem are destined to fail miserably. There is no savior large enough with a magical pool of capital to stave off this unfortunate conclusion to the global debt super cycle... defaults [by all these sovereign nations] are imminent.

If They Are Right, What Is Really Safe?

In truth, we will not know what the safest way to navigate this treacherous economic period was until after the fact. There are many people who see treacherous times coming, and there are many philosophies on how to be best positioned.

Along the winding road of my education about investing I've learned a good litmus test of my investments: do I sleep well? In these economic times, I sleep well with 50% of my holdings in precious metals. It is not an investment position I could have imagined 10 years ago, and it is not one I advocate for anyone else.

The point is that what "risk" is has become something individual investors are responsible to evaluate for themselves. Defining the risk of an investment class based on performance from the 1945 to 1999 years goes out the window if we are at a global economic inflection point, as irrelevant as 1920s performance was to the 1930s. When the inflection point passes, and when central bankers and governments act responsibly, we can go back to classical definitions. In the meantime, what governments and central banks do today is beyond my imagination, and far outside my comprehension of responsibility.

Please do not do what I do. Do your own due diligence and research. Make your own informed choices and evaluations about risk. Sleep well.

Next month: Why I Sleep Better With More Than 20% Of My Money In Frontier And Emerging Markets

Disclosure: I am long GLD, SLV, CEF, PST, TBT.

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