With the US bond market downgraded and European governments facing insolvency, investors are reconsidering investment risk. But in doing so, are they making the right judgements?
The conventional view is to regard cash as the risk-free asset class. Obviously, if you hold nothing but cash, in accounting terms your only loss will be management fees. Other asset classes are judged to have greater risk, depending on their characteristics, such as historical volatility and long-run returns. Both investment managers and financial regulators refer to these accepted yardsticks in judging the suitability of an investment strategy for managed and advisory clients.
For this to be true in actual, as opposed to accounting terms, money has to retain its purchasing power. Regulators make no judgement in this regard, sticking firmly to the accounting identity. The majority of investment managers are ignorant of the distinction, but the few that are are restricted by the regulatory regime.
The point has become important at a time of accelerating monetary inflation. It is obvious that a portfolio’s cash in a depreciating currency suffers real loses, and the riskiest asset class, which regulators most probably agree to be precious metals, actually has the least risk. Despite the truth of this statement being demonstrated by the rise in the price of gold over the last decade while money supply and bank credit became the true bubble, the investment management industry still doesn’t get it. The result is that global portfolio assets have less than 1% exposure to precious metals and related mines, in spite of a six-fold rise in the gold price.
Let us put received wisdom aside for a moment and look at this afresh. The basic reason the price of gold has risen is because of the expansion of money and bank credit. For a while this inflated other asset values in paper-money terms, giving portfolios excellent returns for risk assets, such as stocks and real estate. Bonds also did reasonably well while price inflation remained subdued, relative to the expansion of credit. And though credit expansion has been seriously curtailed in the last few years, the raw money stock has surged dramatically higher.
With the US and European economies stalling, central banks are again contemplating the issuance of more money. The consequence is clear: gold is emerging as the least risky asset class, if it hasn’t done so already. The only certainty for a cash-oriented portfolio is that it will lose real value.
The usual inflation hedges are also becoming riskier as we enter a new economic downturn. Equities have started to collapse. Other asset classes will also struggle to maintain value against the deflating credit bubble. All this is bad news for people who have entrusted their money to unthinking investment managers and advisors.
The investment management industry is unlikely to get the message easily, because of that accounting identity and the mind-set of financial regulators. It is far easier for an investment manager to behave like a nationalised industry and give a higher priority to regulatory bureaucracy than to exercise proper care in looking after their customers’ money.