Portfolio Insurance [GLD]

Portfolio Impairment

The risk that a loss would hurt my portfolio’s ability to recover said losses in a reasonable time frame is, in my opinion, the biggest threat that must be managed closely. What I mean by this is that I don’t want to make a mistake that I can’t come back from without having to make a significant change in my portfolio strategy or lifestyle. Examples of lifestyle changes are having to find ways to increase my income or further cut out expenses in order to reach my goals. A large drawdown in an investor’s portfolio that leads to permanent portfolio impairment can be extremely difficult to recover from. The easiest and most common way for an investor to manage this risk is through asset class diversification.

Obviously, we know that there are benefits to spreading your bets around to allocate risk to different investments and/or different asset classes. The old adage, “don’t put all your eggs in one basket” that we’ve all heard since we were kids. However, it is not diversification for diversification’s sake that is beneficial. This can lead to “Diworseification.” Diworseification (as coined by Peter Lynch) is the process of adding investments to one’s portfolio in such a way that the risk/reward trade-off is worsened. This occurs from investing in too many assets with similar correlations, leaving you susceptible to diversification across assets that could be simultaneously dropping in price. That’s a rather unfortunate situation to be in.

General Thoughts on Asset Allocation

In 1986, Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower attempted to explain the effects of asset allocation policy on pension plan returns. In their study, “Determinants of Portfolio Performance“, published in the Financial Analysts Journal, the researchers asserted that asset allocation is the primary determinant of a portfolio’s return variability, with active management playing a lesser role. According to the Financial Analysts Journal, the study examined the quarterly returns of 91 funds over the 1974 to 1983 period and benchmarked the returns to those of a hypothetical fund holding the same average asset allocation in indexed investments. They concluded that asset allocation explained 93.6% of the variation in a portfolio’s quarterly returns.

In 1997 William Jahnke published a follow-up to their study arguing that “The fundamental problem with their analysis is its focus on explaining return volatility rather than portfolio returns. In fact, investors should be more concerned with the range of likely outcomes over their investment planning horizon than the volatility of returns.” In other words, the study ignored a forward-thinking analytical approach that factors in the idea that as an investor’s circumstances (market opportunities) change, so also should the investor’s asset allocation to align with new outcome probabilities.

The studies gave way to further research from known academics of the financial world, Roger G. Ibbotson and Paul D. Kaplan. They found that only about 40% of the return variation between funds is due to asset allocation, with the balance due to other factors, including asset-class timing, style within asset classes, security selection, and fees.

There have been many additional studies, but I cherry picked those because they are rather well-known and serve to get my point across. The point? Strategic asset allocation matters. One can argue over the level of importance, but to ignore it altogether could be detrimental to successful portfolio management. As a result, I consistently analyze my strategic asset allocation and look for ways to improve it.

Interesting Piece that Caught My Attention

On July 17th, Ray Dalio (Co-Chairman of Bridgewater Associates, L.P.) published a great piece on LinkedIn titled “Paradigm Shifts.” In this article, he explores the many different “Paradigms”, or economic environments that persisted throughout the past 100 years. Dalio conveniently breaks these paradigms into decades (i.e., the 60s, 70s, 80s, etc.) and discusses how one market environment gives rise to the next. In doing so, we can observe that each decade was extremely dissimilar to the preceding decade, yet oftentimes quite similar to other periods in history. Dalio discusses the current themes that describe the “paradigm” that the U.S. is in, and then attempts to deduce what the next “paradigm” might look like. It is a great read that I highly suggest and it can be found here.

Reading Dalio’s piece gave me a few insights as to what themes he believes will define the coming “paradigm.” After reading Dalio’s work I decided to revisit my current asset allocation to determine if any shifts were necessary to prepare for the next paradigm. To draw on William Jahnke’s point, what I really wanted to know is whether my portfolio was constructed in a way that would maximize performance given a potential shift in the macroeconomic environment.

Inflation Risk

I consistently ask myself the following question:

What is the biggest risk to my portfolio that could lead to portfolio impairment and do I have some type of protection in place?

Lately it seems that I keep coming to the same conclusion.


This is a huge risk because it could be detrimental to every asset currently in my portfolio.

Inflation is the decrease in the purchasing power of the dollar (i.e. increase in prices of goods) and it would erode the value of my portfolio in multiple ways. Not only would it diminish the importance of my cash buffer, it would eat into my fixed income allocation and destroy the value of earnings underlying my equity holdings.

What happens to my portfolio when it is not just a single asset that loses 50% of its value, but rather the US dollar?

Bad things.

It doesn’t seem like the threat of inflation, or even hyper-inflation, has picked up steam in the mainstream media. It gets mentioned in passing but I believe it is a big threat to the bull market we’re in. The largest losses always seem to come from unforeseen events and unexpected threats. The media is focused on the Fed and the trade war with China. The Fed is talking about cutting rates further after a 25bps move to 2% in early August, there is still no trade deal on the table, and we are coming up on an election year. No one seems to be talking about what could be potentially bubbling under the surface.

Previous High Inflation Periods

We have not seen high inflation in the U.S. since I have been actively investing (about 4 years). You can see how subdued it has been over the past decade in the below chart.

Inflation has been virtually non-existent since 2000, coming in below the Federal Reserve target of 2% over the past year. However, this clearly has not always been the case as inflation was significant and increasing in the late 40’s and the late 70’s.

In the 1970’s the United States was suffering from a period of “Stagflation”, which was low growth coupled with high inflation. The gold standard was abandoned in 1971 and the dollar was devalued to ease government deficits that had ballooned at the end of the previous decade. Significant money printing ensued, resulting in high inflation.

3 Main Reasons Why I Care About Inflation Today

The following reasons are the main points as to why I believe the current market environment may at some point give way to higher-than-expected inflation.

  1. After the financial crisis (‘08/’09) central banks around the world, including the Federal Reserve here in the United States, embarked on a lengthy period of easy money policies known as Quantitative Easing (“QE”) that poured money into the economy.
  2. The level of fiscal debt and growth of the Budget Deficit undertaken by the federal government is unsustainable and will need to be monetized.
  3. Low Unemployment could overheat the economy.

Let’s start with the first reason.

#1: Quantitative Easing

After the Great Financial Crisis, the Federal Reserve stepped in to put out the fire and help fuel an economic recovery. The Federal Reserve helps to steer the economy by manipulating interest rates. The Fed has the power to directly impact the short end of the yield curve by adjusting the fed funds rate. This is the primary tool used by central banks to stimulate economic growth and create price stability. Lowering the rate encourages lending and spending in the economy allowing business’ and consumers to borrow money to conduct business as usual. The graph below shows the level of the fed funds rate and you can see that after both the tech bubble in ‘00/’01 and the financial crisis in ‘08/’09 the fed cut rates significantly.

In addition, the Fed attempted to impact the long end of the yield curve as well. They did this through open market asset purchases, essentially creating artificial demand for assets and pushing prices up (and long-term rates down). From the end of 2008 through October 2014, the Federal Reserve greatly expanded its holding of longer-term securities through open market purchases with the goal of making financial conditions more accommodative. The spread on the 10yr – 1yr has steadily fallen from a previous high of 3.43% in March of 2010 and is currently inverted.

Below is a look at the total assets held by the Fed.

Ultimately, the point is that the actions by the Federal Reserve resulted in more money circulating in the economy.

#2: Budget Deficit

The rock bottom interest rate environment across the entire yield curve has led to a significant increase in the use of debt. Corporations have used cheap money to expand their enterprises and return capital to shareholders through dividends and share buybacks, helping to prop up the equity markets. Also, the US Government has expanded their debt burden to point where it is now greater than US GDP at over $20 Trillion.

The annual US Federal Budget Deficit for Fiscal Year 2020 is $1.10 Trillion and growing.

Some argue that a budget deficit is not all bad as it increases economic growth. (See: Forbes) Fiscal spending puts money in the pockets of businesses and families and their spending creates a stronger economy. That makes other countries happy to lend to the U.S. government, which has never defaulted and has always fulfilled its obligations. However, when the debt becomes excessive, owners of the debt become concerned that they won’t be paid back. If this results in investor’s demanding higher interest rates this can serve to exasperate the issue, potentially causing a currency crisis. Think Argentina in the early 2000’s. When debt is growing faster than GDP- it is unsustainable. Whether we are at the tipping point remains to be seen and I’m not claiming to know. In a strained economic situation, I doubt the U.S. government would even consider defaulting and, as a result, they would likely monetize the debt. This means the U.S. Treasury Dept. would ask the Federal Reserve to step in and buy the debt by printing money.

More money printing and more inflationary pressure.

Below is a look at the explosive growth in the monetary bases since the fed began its “easy money” policies after the financial crisis. The monetary base is the total amount of currency that is in general circulation in the hands of the public or in the commercial bank deposits held in the central bank’s reserves. Inflationary Monetarist theory suggests that inflation will occur at some point if the supply of money is increased and it has increased dramatically since the financial crisis.

#3: Low Unemployment

As of writing, the unemployment rate sits at 3.7%. The lowest rate since Nov. of 1986

The relationship between inflation and unemployment has traditionally been inverse, however, it should be mentioned that the relationship has broken down on several occasions. Theory goes that in times of low unemployment, the demand for labor exceeds the supply of it. As a result, workers are competitive over wages because they can go down the street and get another job. This leads to wage inflation, which ultimately puts more money in the hands of consumers, who then go out and spend it. Consumers are willing to spend more on products creating demand and corporations will need to raise prices to make up for the higher wages they are now paying their employees, as well as the higher prices for raw materials. This phenomenon is known as cost-push inflation.

But Where is Inflation?

I can’t claim to know for sure. But I find it interesting that we could be exiting a “Paradigm” that was defined by QE, a ballooning national debt, and an all-time low unemployment, yet there has been no inflation. There are multiple theories as to why we don’t see rising inflation given the onslaught of inflationary pressures. One popular one I’ll mention is the slowdown of the “velocity of money”, or in other words, how quickly money circulates throughout the economy. The formula is simple:

V = PQ/M

  • V = Velocity of money
  • PQ = Nominal GDP, which measures the goods and services purchased 
  • M = Total, average amount of money in circulation in the economy

The argument is that in the short term, the velocity of money is highly variable, and prices are resistant to change, resulting in a weak link between money supply and inflation. Perhaps this holds true in the short-term, but ultimately, I believe the evidence suggests that money printing and debt financing will eventually lead to inflation.

To quote Ray Dalio one last time, he concluded in his paper that, “it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.”

As such, on August 5th I bought shares of the SPDR Gold Trust ETF (GLD).


I find the argument compelling. Given that gold is a reasonably strong inflation hedge and has a low correlation with the equity market, I have added it to my portfolio as a form of insurance.

My intention was to pay mind to the aforementioned studies by respecting the importance of asset allocation while doing so in the context of the current macroeconomic landscape.

All over the world, throughout history, and today, gold is viewed as money. It is considered a global store of value and has maintained its value since ancient times. Societies have been experimenting with what they use as money for decades. Gold became the victor through centuries of trial and error.

You can see in the chart below that historically, and over the long-term, there has been a negative correlation between stocks and gold. This was evident after the 2008 crisis when the Fed conducted a series of rate cuts and Fed Fund rates moved towards zero. Gold prices performed exceptionally well during that period and reached an all-time high of around $1900/oz. Another previous example includes the 1970’s (high inflation prevailed).

Position Sizing

The current purchase makes GLD roughly 2.0% of my portfolio. I expect this position to increase during periods of stress on the portfolio or periods of inflation. I have given it a max allocation of 5% and will trim and reallocate to other asset classes (preferably equities) that would, in theory, become cheaper during these times. I do not intend on letting Macroeconomic and Geopolitical forces derail my investing progress though permanent portfolio impairment. I view my gold position as a hedge to these forces and will continue to grow its allocation as the portfolio grows.

Questions? Comments? Do you own Gold?