The mark of a quality investor is that the person can differentiate between safe and unsafe assets. Differentiating between them is a skill that needs to be acquired over time and often through painful experiences.
What is an asset? An asset is something that you can legally purchase with your capital with an expectation of receiving a return that is greater than the capital that you have used to purchase it. Investopedia gives the definition as “a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit”.
What are the conditions to be fulfilled for an asset to be considered safe? That is a tricky question. The main thing to remember is that nothing, absolutely no single asset is 100% safe.
The safety of an asset is relative – relative to each other, and relative to the investing environment. In the long run, equities have turned out to be safer than supposedly safe bonds that whose value was eviscerated by inflation. Conversely, deflation did the opposite to equities, just ask any Japanese investor who was loaded up on equities in 1989. What is relatively safe in a non-crisis situation may all of a sudden appear flimsy in the face of an unexpected event, such as a devaluation or recession.
Not to be underrated is the role of law in defining and nurturing safe assets. If you can imagine the asset as a drink to parch your thirst, then the law is akin to the glass that contains it:
- The glass separates what is within from what is outside the glass, it delineates the rights and protection accorded to you as the holder.
- The glass gives the drink holder possession, you can drink it or you can give it up to another. You get to decide what to do with it.
- The glass gives it portability, you can take the water from the tap and set in on the table for someone else to offer for it. That is, the rights and protection are transferable, therefore it can be bought or sold.
The law not only upholds rights, but also ensures that the value creating activities of the asset continue to be legal and valid. A long list of other instances where without the backbone of the law, the safety of assets become a pointless study. The law, and hence, the institution that upholds the law, is important for the existence of safe assets.
Another crucial point around the safety of an asset is that others will want to buy it from you without a large discount when you wish to sell it. Thus, safety is also related to the market valuation of it.
Precious metals are anything but safe in protecting future purchasing power given their limited industrial use. The paper entitled “The Golden Dilemma” by Claude B. Erb and Campbell R. Harvey sums up the difficulty in determining whether gold continues to be a safe haven,
In the end, investors are faced with a golden dilemma. Will history repeat itself and the real price of gold revert to its long-term mean – consistent with a “golden constant”? Alternatively, have we entered a new era, where it is dangerous to extrapolate from history? Those are the uncertain outcomes that gold investors have to grapple with and the passage of time will do little to clarify which path investors should follow.
Gold has high market liquidity. However, this is an FT’s article from last year on the falling liquidity of gold. At one time, gold was considered as dollar hedge, inflation hedge, portfolio diversifier and safe haven.
Gold Price 1975-2015
From the paper “The Gold Price in Times of Crisis” by Jedrzej Bialkowski, Martin T. Bohl, Patrick M. Stephan and Tomasz P. Wisniewski,
The most likely explanation for the gold price boom from 1979 to 1982 is that skyrocketing inflation (caused by the second oil crisis and amplified by a very expansive monetary and fiscal policy) and geopolitical turmoil (due to the beginning of the Iran/Iraq war and the Soviet invasion of Afghanistan) caused financial market participants to look for stable investments in unstable times. Similarly, many investors might have returned to gold as a safe haven in times of the recent world financial and, in particular, the current European sovereign debt crisis, thereby creating excess demand and the corresponding price surge. In presence of serious questions regarding the viability of the banking sector and the international monetary system, the acquisition of gold represents a perfectly rational reaction on this part of investors. It is important to stress at this stage that our proxy for the severity of the debt crisis, which is derived from the sovereign bond yields of the PIIGS countries, is absolutely crucial to explaining the recent evolution of gold prices.
In contrast to gold, some assets create value. Let’s look at the minutiae of these assets. First, the knowledge of how the asset create value for the owner must not be opaque. Opacity of value creation, especially in the presence of Ponzi schemes in many guises, cannot be emphasised enough. The less of an idea you have of how the asset creates value, the more suspicious you must become. Do not let the temporary appreciation of its market price lull you from actually investigating the mode of business, the cleanliness of its balance sheet or the validity of the appreciation that the asset promises.
Second, who owns it and who has a say in its future. Those two are sometimes the same, as is the case with family run companies. There are also the presence of activist shareholders, their purpose and efficacy are currently hotly debated. Be aware that in some countries, what looks like a public company is actually a government’s petty cash box in disguise, especially resource companies. Look at the ownership structure and who gets what when bankruptcy happens.
Third, what is the likelihood that the asset does not deliver its promise? Either through failure of execution, difficult circumstances, or even fraudulent behaviour. For bonds, it is the probability of default. For most of assets, ratings agencies and analyst ratings may be a good guide but uncertainties will always remain. It is for this reason that investors demand a risk premium, which is low for high grade bonds and infrastructure and high for projects where cash flows are years away.
Therefore the bigger the ambition of any asset, the greater the range of confidence of people judging the outcomes. Remember the saying, in the short run the market is like a voting machine? How the market views the asset matters if the duration of your holding is less than long run. Most of the time a simple rule applies: the easier an asset is to value, the more commonly held the view of its value is, the safer it is.
Fourth, diversification is an important consideration here too. An asset by itself may be risky but due to low correlation with others may provide more safety than a single, much safer asset.
Lastly, safe today does not mean safe tomorrow. The sharp drop in the USD recently shows how tenuous the position of the crown-wearer of the ‘safest’ asset can be.
EightAteEight 