How do I protect myself against inflation?

A friend, lets identify him by Mr. P., recently contacted me, here is what he said:

Mr. P.:

jrv,
First, I want to thank you for the excellent work you’re doing with your blog. There’re tons of very good, well-processed information.

I don’t know what’s your general feeling about how things are going in the world, but personally I’m getting quite worried about a number of topics. To say it a bit bluntly, I think stock picking is a complex activity and it is important to get the type of information you’re providing in order to make educated investments, but at this point, I think the problems are getting more essential in terms of economy and energy. I doubt we can really be mindful long-term investors at this moment if we only focus on stock picking. The dynamics that have been at play for the past 4 years are unfortunately proceeding as expected. The debt crisis indeed made it to become a sovereign debt crisis. Looking at government liabilities and other commitments in Europe and US is just daunting. I guess there’re only 3 ways out. First cleaning the mess and reforming. Since that’s very unpopular, we know it won’t happen. Second, defaulting on sovereign debt. Some countries will probably do it, like maybe Greece, but that would only come as an extreme outcome. I’d bet that before defaulting, governments will rather go with option 3, quantitative easing and other money printing mechanisms. That’s the path of least resistance, for now. As we know, money printing is nothing else than a tax, since it decreases the intrinsic value of money and therefore reduces the value of our cash. Energy is an entire other beast, it is at least as scary, but we can discuss that a bit later…

Anyway, for now, I have only 1 question: what do I do with my cash? I know that cash is doomed. We’ll get soon enough to heavy currency crisis. So, while I don’t discard stocks as a protection against money printing, at this point I’d like to evaluate many more asset classes to take the most appropriate decision to protect what I have. What would be a proper strategy of asset allocation ? How to split between cash, money markets, bonds, stocks, commodities, real estate, art,…?

Have a nice Sunday

to which I replied:

Thanks for the blog comments I really love writing and structuring my ideas, it has really helped.

Good question. Let me first say that any asset I buy it will be in something I understand, and since I have little idea about art and I do not like the non earnings producing nature of commodities and their very obscured means to analyze them, I’ll pass on by those ones. Me and Bieke personally have the house (~80% paid) and three grounds in Chile (one big, two small), stocks and cash split in this way: 30% cash, 53% real state (at basically the same prices I bought), 17% stocks. I could almost duplicate my sock position but I do not do it due partially to the same concerns you have and if I add substantially more it will be only if I see cheap possibilities. I completely agree that stock picking is risky and I strongly discourage it unless you do it on a full time basis. The reason being because it simply requires to much study and the biggest risk is not being convinced and informed when you buy. Therefore if someone considers going into stocks it should be done by buying a cheap-commissioned market index etf (like iShares) on a constant basis (to avoid market timing risk), i.e. every month buy the same amount of money in some indexes: Europe, Asia, USA, emerging… That is the best for passive investing.

I like real state but I do not love it, it is a good way not to lose money but it does not produce either, I bought when I did not know about investing, but yes, at least it protects you from inflation if you chose well, I have the chance I can rent the big ground to some neighbors with cows so at least I get something additional. If I wanted to add more on real state I would take a plane to Florida and buy some apartments or houses with good renting power, but I already have too much real state, bought cheap, and I am to lazy to go to the states alone, I hate leaving my comfortable surroundings .

For me, I like investing in stocks, due to their earnings power and some are a good protection against inflation (read the article from Buffett “How inflation swindles the equities investor” in this blog) and I plan to have more but will only buy a lot in any company if it gets very cheap, that is why the latest additions I have done, as you may have noticed, are very small.

My big concern is also currency debasement and inflation and I am considering the following practical solutions. A straight protection in buying inflation protected bonds like TIPS in the USA or the equivalent one in Euros, you will not earn much but you will also not lose since they produce much more money when inflation comes so they do not lose so much principal value. Another option is insuring yourself, like Seth Klarman, he considers the possibility of a huge inflation risk too so he is buying way deep out of the money inflation puts that can multiply if there is more than 10% inflation I think that is quite easy, there are instruments available for that. You should buy puts with at long strike dates from now, 2,3, 5 years. Its like buying cheap insurance I am considering to do the same. A third possibility and the easiest to do in practical terms is to short bonds, in case of inflation they will get for sure devalued, there are tons of people thinking bonds are the next or the current bubble and they have very good arguments. They say that not much has changed that the debt ball was simply passed from private to public hands, so the next bubble is in the public sector. If I short bonds I would consider shorting a municipal bond etf or 10 to 30 year treasury bonds such as the TLT etf. Municipal bonds are the worse because they can default, even worse than state bonds, which will not default, because the can always print more money. Even though USA sovereign bonds cannot default they can lose a lot of their principal value with inflation, that’s why I like shorting them as a hedge against inflation.

Cheers!
jrv