The Deflation Protection Portfolio

by Wes Bridel on April 15, 2011

in Stewardship

Deflation Protection and other Asset Allocation Examples

There is no end to the possibilities of asset allocation.  We are going to list several examples of asset allocation here over the next couple weeks because it seems like a good way to understand the mindset in creating each allocation.

We’re going to look at this mostly from the mindset of a Macro Economic Thinker.  Traders don’t asset allocate/diversify in exactly the same way, but we will go over a couple trader scenarios.  The other two styles mentioned previously certainly should diversify in one way or another, but again their focus is different.  The asset allocation studies we look at below will have a big picture perspective.

Today, we’ll start with…

The Deflation Protection Portfolio

Jack & Betsy have lived a long life together and seen good times and bad.  They can just remember childhood during the Great Depression and marveled at the many changes for better and worse the world has gone through over these many decades.  One thing they know for sure is that they need all the income they can get from their life savings, but at the same time don’t want to take any unwanted risk in these crazy markets.  Jack has heard of hyperinflation, but in all his many years, he’s never had to worry about anything like that and doesn’t plan to start now.  Still, the boys in Washington seem to have really messed up this good country and “you never can tell” so he’s willing to take some precautions.

Betsy is just sick of all the risk.  They got sucked into the excitement of the stock market like so many others over the last few decades and although it was wonderful at first, they’re now left with less than they started with.  “No more risk” is her motto.

Jack and Betsy like the idea of avoiding all risk of loss, but the more they study, the more difficult that sounds.  They end up designing what they call “The Deflation Protection Portfolio”

Because Jack and Betsy remember what the Great Depression was like, they are primarily concerned with the threat of deflation such as we saw in the 1930’s or like Japan has experienced over the last two decades.  In such a time, they know that cash is king, interest rates are typically dropping lower and lower, the economy and corporate profits stagnate.  Most people are devastated, but those with capital and income do ok because prices decrease everywhere.

Here are the assets that make up their allocation:

Gold

Long Term Corporate Bonds

ATotal Return Fund

Long Term Treasury Bonds

A Short Oriented Fund

A High Dividend Paying Stock Fund

Jack and Betsy settled on this allocation because of their philosophy that simplicity is best.  Gold represents real money which is rare in a world of fiat currency and does extremely well anytime that a politician or central banker talks of “quantitative easing” and other measures aimed at “curing” the deflation.  Jack’s parents told him how gold had been adjusted from $20 to $35 an ounce when he was a baby and he’s since seen its value climb over $1,300 an ounce!

Their next three holdings are all based upon bonds which promise a fixed stream of future payments.  In a deflationary environment, these would do extremely well because the value of the bonds would increase as new bonds are issued at ever lower rates.  Also, the income that these bonds pay now will be superior to these future rates so even though it’s not much Betsy likes the idea that they know they’ll have this income coming in.  Of course, if this Jack & Betsy are wrong about deflation and inflation shows up, these bonds would all lose value as the market rates would be higher than these holdings.

In particular, the long term Treasury Bonds pay a stream of future income which is higher than shorter term bonds and guaranteed by the US Government.  The long term corporate bonds will pay an even higher rate of interest because they are only guaranteed by corporations instead of the government.  However, Jack feels comfortable with this fact because he’s read that US corporations are holding such high current levels of cash.  The total return fund is mostly a bond holding as well, but which is placed into the hands of an experienced and capable capital allocator who is able to move into different areas of the market in order to best take advantage of circumstances as they arise.

The bearish fund speculates on sectors and companies that will be hurt the worst in bad times.  Jack has seen enough up and down markets to believe there are more stock market crashes coming.  He knows that a deflationary environment is an excellent time to have such a holding in part because it offsets the long holding that rounds out their portfolio.

The dividend fund focuses on companies that pay large and growing dividends.  These are companies that take seriously their responsibility to the investor and return capital to them.  This holding is excellent in choppy, up and down, sideways markets because the high level of income that is paid.  Betsy is only comfortable with a stock that she knows is going to send them real income, not hopes and dreams.

Jack and Betsy are getting along in years.  They know that this might be a terrible portfolio to own in an inflationary environment.  However, they feel like they don’t have too much longer to go and don’t want the alternative of a portfolio that’s constantly gyrating with every new cycle of news. They feel that this portfolio will be an excellent one for them since they are concerned about maximizing their protection from deflationary pressures.

This is Part 1 in a new series on Real Life Examples of Portfolio Management.  We just finished a series on the different types of investors which you might want to check out at the following links:  Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, & Pt 6.

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