Thursday, July 28, 2011

Risks Inherent in Risk Protection

Given the amount of macro risk currently facing markets, we have a number of hedges employed in our portfolios for different scenarios. If you’re a fan of the deflation argument, we own some long maturity Treasury bonds. If you’re more worried about inflation or monetary debasement, we own some gold. If the risk of further deterioration in the euro-zone and common currency is what keeps you up at night, we own a U.S. dollar index fund. If you’re skeptical about all of those scenarios, we’ve also simply increased cash weightings, willing to temporarily accept 0% yields as a trade-off for principal stability. These hedges all contribute to portfolio protection in certain scenarios, but they also have their drawbacks as they are volatile and carry their own risks.

Long maturity bonds are at risk to a reacceleration in the economy, and the debt ceiling not being raised in time. Gold is at risk to less global liquidity, a higher dollar, and a rise in real interest rates. The dollar is at risk to a continuing downtrend in real interest rates, debt ceiling dynamics, and plain old relative underperformance in U.S. real growth rates vs. other economies. Even money markets take on some risk in the form of embedded European debt exposure and uncertainty regarding the possibility of a U.S. credit rating downgrade.

Given that every hedge has its own risk, what’s an investor to do? If you want to insulate your dollars with 100% certainty, I suggest stuffing some cash in your mattress. Of course that only works if you can live with the risk that your house may catch on fire, you get robbed, etc., etc., etc…