How to Invest Now and Prepare for The Next Inflation

Posted on November 9th, 2009 by admin in How to Invest

In a previous post, we showed why inflation is almost inevitable.  What is a good way to prepare our portfolios for this economic condition in view of the major uncertainty of the timing of inflation expectations?

We set forth a somewhat formal answer in our post on the three main economic scenarios, deflation, neutral and inflation. We want to present a more intuitive answer below.

First, we need to set the stage.

As we have discussed, the Efficient Markets Hypothesis (EMH) is an idea fiercely defended by a variety of senior finance professors, in spite of massive evidence to the contrary. Our post here gives a good summary of what the EMH is, why it is wrong and how it leads to mistakes.

The issue revolves around the implication of EMH that active management is a waste of time and money, since no amount of work can produce more insight than everyone else in market has or can get, and so an investor can get only the market ROI overall over the long run. Thus, according to the EMH, one should just invest in index funds.

OK, let’s stipulate EMH is useless. Now what? How should we invest? Before answering this question, let’s also stipulate, for obvious reasons, we cannot avoid this question.

One answer could be, just give our money to an advisor and let him invest for us. But of course, that raises the question as to how one chooses an advisor who if not sufficiently skilled, is sufficiently lucky. So we need to define an investment strategy.

In spite of all the confusion and uncertainties, one can still make some rational investments, while staying emotionally calm. Let’s define assumptions for a strategy:

The goal is to maximize our ROI, subject to a level of risk we can tolerate. Clearly, the ROI and the risk level are both subjective. We are willing to take more risk to get larger ROI. But the relationship between those two large factors is not known in advance.

We believe the current economic condition is mainly deflationary (prices are dropping and being a creditor is good).

We want to hold securities in such a way that when we discern inflation signs, we can switch easily from the current deflationary position to an inflation stance.

In our case, we want to preserve capital, but have growth reasonably better than that of money market rates (which are now ~0%/YR). This is the risk avoidance component of the strategy. Additionally, we want exposure to some upside to growth. The allocation between our risk avoidance securities and the upside-capture securities is where emotion enters the framework.

Our specific recommendation: account for deflation buy owning a variety of bonds and bond funds. Position the portfolio for upside by owning equities in companies in sectors which we believe are especially promising in the current political-economic environment. This idea, of course, is a standard approach, but modified by a strong emphasis on a small amount of very high risk/high payoff equities. The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

The portion devoted to capturing future innovations or even disasters through equities can of course be enhanced by using various combinations of long dated puts and calls.

Using this broad approach, we can manage risk simply through the allocation between fixed income and equities, and focus on higher risk equities to be exposed to upsides from innovation.

This is not what is called well-diversified….rather, it’s a bet on specific beliefs. Remember, if you diversify enough, you effectively index everything.

Finally, some examples: First, the online, medical records sector, which will be quite actively converting old medical records to electronic format, as well as creating new records electronically, and the semiconductor industry, which continues to grow and also acts as a leading indicator of economic revival.

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