A question arises frequently by those looking to hold hard assets in a portfolio:

Should I buy commodities or gold for my asset allocation?

This question has been covered here before, but I’m going to give three short and sweet reasons why gold is superior to any commodity fund you can buy:

1) Gold is a commodity and is also a monetary metal. You can get the protection then of both. In 2008 when commodities crashed (losing 50% in value very quickly!), Gold posted 5% gains. When the banking system was in shambles, gold was viewed as a form of money independent of what overall commodity prices were doing.

2) I don’t think most people really understand how commodity futures funds work (I don’t and I admit it). Investors shouldn’t buy anything they don’t understand. Gold is simple.

3) Gold has a track record of responding very strongly to currency problems that no other asset possesses.

The Permanent Portfolio uses gold as its primary protection against inflation. Recently there has been a lot of promotion about Collateralized Commodity Futures (CCFs) from companies like Pimco. The claim is CCFs provide better inflation and unexpected event insurance for portfolios than gold and other hard assets. I think this is simply a marketing claim that has many problems. 

In response to an article that Larry Swedroe wrote called All That Glitters is Not Gold I present a short list of why Gold is better than CCFs for high inflation and other currency crisis protection: 

1) He is data mining from a period of time when gold was at speculative peak to make his point. I can pick any investment asset (stocks, bonds, etc.) and do the same thing to make any of them look bad. 

2) He fails to consider the market conditions at the time that may have been driving the high price in gold. For instance, the Prime Rate was 20% in the early 80′s and 30 year mortgages in the mid-high teens. Who’s to say the dollar wouldn’t have kept falling if the Fed didn’t finally get a handle on things? 

3) He’s not looking at how the asset does in a diversified portfolio but looking at it in isolation. Diversification only works when you hold multiple uncorrelated assets together. It doesn’t work when you concentrate your bets because if you’re wrong you can take tremendous losses. If you concentrate your bets on stocks, bonds, cash, real estate, etc. you can and will have the same problem of too much risk. 

4) He’s working with piles of simulated data on CCFs to draw his conclusions against an asset (gold) that actually existed.  Gold has been tested under high inflation and currency debasement conditions for thousands of years in countless countries.  Many CCF funds have been around only six years based on only about 40 years worth of data for their simulated backtested performance numbers. 

5) Treasury Inflation Protected Securities (TIPS) have been around for only about 10 years in this country (since 1997). They are a completely unproven high inflation hedge. He assumes that they are going to respond well to high inflation when in fact nobody really knows what they’ll do compared to gold. At the minimum, even if TIPS keep up with inflation they will not go up enough in value to offset the impacts of inflation in your other investments (unlike gold which has done this in the past). 

6) Physical gold ownership has no counter-party risk and is very easy to understand compared to complicated and opaque CCF funds. CCF funds could be engaging in activity behind the scenes that puts you at risk but you may never even know. 

7) Gold is a commodity, but is also a monetary metal. So you get the protection of commodity ownership but also the protection during financial crises that are threatening the currency. 

8 ) CCF funds are expensive and tax inefficient compared to gold. Gold ownership usually includes a small storage and insurance fee unless you hold it yourself. Other than that it generates no taxable events until it is sold. 

9) As 2008 has shown, when banks are teetering on collapse people are happy to hold gold to hedge the risks but are not happy to hold CCF funds which were brutally wrecked. Gold was up 5% in 2008 and CCF funds were down over 50%!

Gold is far better as a hard asset over commodity funds. It is easy to understand, easy to buy, easy to sell and reacts strongly to conditions that are bad for many other investments (such as high inflation). If you are going to purchase a hard asset for your portfolio (as the Permanent Portfolio does) then you should only buy gold and leave the commodity futures funds alone.

An article in Forbes magazine tries to make the case for devaluing the dollar by 40% to help out the economy:

Why not attack the situation in a manner that will benefit most everyone, an approach that has been successful before and, when compared to the current course, has little downside? Here it is. Stand back. World currencies should be devalued overnight.

The Forbes article is riddled with errors about inflation and the gold standard that I won’t address in this post. The short of it is that devaluing the dollar by 40% won’t do anything at all except force the prices of everything else in the market up by 40% overnight as businesses move to protect themselves. It would also drive interest rates on loans through the roof, put many companies into bankruptcy, wipe out huge portions of savings of the average American and make a bad economy much, much worse. 

So what if? After all, this is Forbes Magazine discussing the idea so someone thinks it’s good. How would you want to position your finances if the threat of a massive inflation to solve our problems came to pass? 

For severe inflation you want to be in gold, commodities, and other tangible assets. Real estate may also be another option, but is not a very liquid investment which causes its own problems. 

You want to be out of long and intermediate term bonds and cash which will rapidly lose value. In the long-run stocks should beat inflation. However, in the short-run stocks will do poorly during high inflation as businesses have a hard time adjusting to rapidly increasing prices. Short term government bonds and money market funds may tread water OK but won’t be profitable. Treasury Inflation Protected Securities (TIPS) may also tread water again without much profit. Then again, risks could show up in this situation that would even effect these bond holders dramatically. 

The true worst-case inflation scenarios includes things like price, wage, capital and exchange controls which always are tried when governments are scrambling to prop up their currencies. These actions are all tremendously bad news for an economy. If you ever hear high-ranking politicians openly talking about doing such things you should be prepared to move quickly to protect your money by shifting it into tangible goods, hard assets, or moving it into another currency (preferably in a foreign bank) if possible. Even this is not foolproof as governments would likely put up blockades to trap as many people as possible before a serious devaluation would occur. 

But this is all worst-case scenario. Does it happen in real life? 

Well, in Argentina before they devalued the peso in 2001 they implemented capital and exchange controls. These controls forced citizens to repatriate foreign funds, froze all bank accounts, limited how much money could be removed at any one time, and converted all domestically held accounts in Euros and Dollars into the Peso before they did the devaluation. The Argentinean peso lost about 80% of its value shortly thereafter, decimating the life savings of their citizens. Nice huh? 

Just because the US Dollar is the reserve currency doesn’t rule out the use of high inflation to try to solve economic problems either. The question is, can it happen here? Well, it almost did. The decade of the 1970′s wasn’t bad just because of Disco. It also saw double digit inflation with the prime rate over 20% by 1980. It also saw price and wage controls, shortages of oil and other staples due to these controls, and a destruction in the standard of living for working and retired Americans on fixed income as the value of the dollar sank by 50%. So this type of scenario has happened even in the US and was only averted after a very painful recession that capped off 15 years of flat stock market returns. The next time it occurs we may not be so lucky.

This is all an extreme situation, but it’s always a good idea to consider how to deal with problems you think are unlikely right now. For this reason, I think all investment portfolios should hold some percentage of their allocation in hard assets as insurance in case a bad inflationary situation unfolds. More on that in the future.