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Risk in Your Portfolio - gold as portfolio hedge

THE MAGINOT LINE

This article examines the way a typical wealthy person invests his money to secure his future.  It exposes the error in the thinking of the huge majority of investors and explains how almost all investment strategies suffer from the same weak spot.  It also explains how to plug the gap - cheaply.

History is littered with failed attempts to assess risk. One sad example was the response of the French to the horrors of the First World War. Having suffered immense loss of life in the trenches in eastern France they constructed the Maginot line - a series of expensive super-forts along their eastern border with Germany. They reckoned the forts were so strong that they would prevent any future German army from attacking. In a sense, of course, they were absolutely right. Hitler didnít take on the Maginot line, instead he blasted through Belgium, and Paris was taken in weeks, not from the east but from the north.

The Maginot line was an expensive but ill-located and ultimately unsuccessful investment in security. Most of us undertake our equivalent investments in personal security through the insurance industry. We build our own little line of forts, to secure ourselves and our families against the possibility of future financial onslaughts.  Many of us cover some of the following risks :-

But wealthy people understand that insuring against these risks is usually a waste of time and money. With these high probability events the protection offers little more than a smoothing of cashflow.  By taking out insurance they will pay out smaller amounts regularly, and receive larger amounts irregularly. Since they donít have a cashflow problem there is no benefit in the smoothing effect of insurance, so the only thing which matters is the gross premium cost against the gross claim. The odds, of course, are overwhelmingly against buying the insurance, so for them the smart course is "Don't bother".

But even for them some risks concern genuinely unlikely events which would be financially disastrous. Even they are justified in insuring to cover the relatively small chance of their family's financial destruction arising from :-

These insurance contracts make sense even for people who donít ordinarily have a cashflow problem. They are not about cashflow but about unaffordable and genuinely improbable risk - which is what insurance was really invented for.

So the strategy adopted by many financially shrewd people with regard to insurance is to buy cover only where without it they would not otherwise be able to repel a particular attack on their finances.  They have worked out that the stronger the mobile standing army of their general finances, the fewer forts - i.e. the less insurance - they actually need.

All that is left is to decide where exactly are the main risks.

So how many wealthy people in their thirties, forties and fifties can think of a risk which is statistically many times more likely than the previously listed disasters, which would be financially ruinous, and which is completely uninsured? Probably no more than 1 in 10 could identify the risk. Probably less than one in 10,000 has covered it.

The risk is loss arising from the collapse of a large part of the financial system. The Maginot line of peoplesí private insurance arrangements has been built. But the most likely case is that their financial destruction is threatened not from the east, through the relatively improbable and isolated disasters which befall individual men and women, but from the north, from where comes periodically the cold wind of general financial chaos, which destroys almost everyoneís finances at the same time.

When instead of a private disaster there is a public financial catastrophe the number of victims could be a thousand times, or even a million times larger. The UK Lloyds of London debacle ruined tens of thousands of Britainís wealthy. The Argentinian collapse has ruined millions of scrupulous Argentinian savers. The Great Depression wiped out the financial fortunes of tens of millions of industrious and successful citizens of the world. Nothing like these numbers of wealthy people have ever been affected by all the insured premature deaths, house fires, personal injuries or liability claims of the twentieth century put together. Yet all these financial disasters, and many more like them, have occurred within the last 100 years.

The fact is that financial crises of the largest magnitude are really quite common, and a pre-requisite of these accidents is that the huge majority of their victims regard them as impossible.

Stand back for a moment and consider how most wealthy people have secured their accumulated capital. They have already bought a nice house. Their surplus is invested in stocks, bonds, mutuals, property, their own business, or whatever else their private investment preference dictates. They may have chosen well on the basis of recent historical rates of return, but all of this wealth is at risk in a general crisis - even on deposit. In a financial collapse stock and house prices plummet but nothing can be sold. Banks cannot pay back depositors and government deposit guarantees become hyperinflationary and are worthless. This happens in at least 1% of years, ordinarily in circumstances not so dissimilar to those around us now.

As luck would have it the insurance needed to defend against that type of catastrophe is just about the cheapest form of insurance it is possible to buy. The reason for this is because - necessarily - it does not involve any insurance companies or other financial organisations. In a world of financial crisis gold bullion can be relied upon to hold and multiply its value.

Consider a respectably wealthy individual with $500,000 of invested assets. He is successful, earning $100,000 a year - probably as some type of professional. Consider the options of investing in gold or depositing cash to the value of $75,000 - being 15% of capital. Taking that $75,000 out of the mainstream financial system (where it is earning 1 or 2% max) will cost $750 to $1,500 pre-tax per year, not even covering inflation. Now justify a capable working person fussing over an additional $1,500 of income when the capital which produced it could be used so effectively to make him rich in a relatively probable crisis of the type which might cost him his capital and his job simultaneously.

This is the justification for making an investment in gold. All the other principal investment classes of the world depend on the solvency of another organisation bound up in the financial system.  Gold does not. It is the quality hedge against the commonest personal financial disaster, in terms of numbers of people ruined. It is a hedge against a failure of the financial system itself.


source www.galmarley.com