10 year TIPs vs. Gold

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10 year TIPs vs. Gold

Postby grok87 » Wed Aug 25, 2010 10:09 pm

With the 10 year TIP real yield now below 1% (hit 0.97% today) one might ask if it's still worth investing in TIPs. Maybe Gold is better as an inflation hedge?

Not a chance- TIPs are the way to go. Here's the way I think about it- assume you have a 10 year holding period. Then:

1) 10 year TIP (purchased at auction):

Expected annualized return: 0.97% + Inflation

Risks- while the above seems simple and straightforward there are two main things to consider. Firstly there is a guaranteed minimum repayment of par at principal. This is handy if there is net deflation over the 10 year period-i.e. this a good thing, not really a "risk"
Secondly there is the possibility that the US government starts manipulating the CPI stats over the period. In this case CPI might lag actual inflation. This is unlikely but not impossible (Argentina has done it).

2) Gold (assume the GLD ETF)
Expected annualized return = Inflation - 0.40% (the e.r.)

Risks- while in the long run the price of Gold might be expected to track inflation, in practice it can deviate for long periods. THe red line in the chart below show the inflation adjusted price of Gold
http://inflationdata.com/inflation/imag ... _chart.htm
Over the past 100 or so years, this inflation adjusted price has been quite variable ranging from around $250/oz to $1781/oz. So the odds that the actual return of Gold would exactly track inflation over any actual 10 year period seem quite low. Yet Gold investors don't get any compensation for bearing this volatility risk. On the plus side however, if the government calculated CPI understates inflation (see comment above) then Gold might be expected to track actual inflation as opposed to the lower CPI.

3) So to sum up, compared with Gold, TIPs have a higher expected real return of 0.97% vs. -0.40% for Gold. Plus TIPs have upside in the the case of deflation. The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers) whereas the risk of Gold is a very real one- as the historical record shows Gold tracks inflation only in the very long run, in the short run the tracking error can be huge.

cheers,
Last edited by grok87 on Wed Aug 25, 2010 10:38 pm, edited 1 time in total.
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Postby market timer » Wed Aug 25, 2010 10:32 pm

Are you saying the market is not efficient?

Interestingly, according to the BLS (http://data.bls.gov/cgi-bin/cpicalc.pl) $1 in 1913 (farthest back it goes) had the buying power of $22.02 today. Gold was $20.67/oz back then, implying a real return of 1.04% based on its current $1240/oz. If you expect the same long run real return going forward, it's not far from today's 10-year TIPS.
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Re: 10 year TIPs vs. Gold

Postby Roy » Thu Aug 26, 2010 8:25 am

grok87 wrote:The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers)...


What "hypothetical" risk for TIPS—not related to governmental "fudging" of inflation numbers—showed up in 2008?
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Re: 10 year TIPs vs. Gold

Postby SSSS » Thu Aug 26, 2010 10:16 am

grok87 wrote:2) Gold (assume the GLD ETF)
Expected annualized return = Inflation - 0.40% (the e.r.)


You can buy a fire-proof lockbox for about $20 and hide it under your bed; no expense ratio required. 0.4% is insane... what are they actually doing with that money?
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Postby grok87 » Thu Aug 26, 2010 6:39 pm

market timer wrote:Are you saying the market is not efficient?

Interestingly, according to the BLS (http://data.bls.gov/cgi-bin/cpicalc.pl) $1 in 1913 (farthest back it goes) had the buying power of $22.02 today. Gold was $20.67/oz back then, implying a real return of 1.04% based on its current $1240/oz. If you expect the same long run real return going forward, it's not far from today's 10-year TIPS.

Thanks for the data. As the chart I posted shows, the real return of gold is quite variable (obviously gold prices are quite volatile). So I suspect that, as theory would suggest, their is not a persistent positive real return for holding gold over a variety of time periods- rather I suspect it is an artifact of the starting and ending points of the time period (1913-present). But I will look at the data when I have a chance...
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Postby nisiprius » Thu Aug 26, 2010 6:55 pm

Apart from the fact that they are called inflation hedges, I don't see how TIPS and gold can be considered comparable in any way.

It's like comparing a AA alkaline battery with 5 grams of gunpowder. They are both called "energy sources" (and they both contain about the same amount of energy, 15,000 joules, if I Googled and calculated correctly) but I can't imagine any situation in which they would do the same job.

The TIPS are like AA batteries, undramatic, boring, eking out a modest steady real return. They track inflation in detail, accurately, in real time as it were. What they do is governed by contract and predictable.

Gold undergoes wildly speculative swings like gunpowder exploding. In the long run it is expected to have zero real return. Gold advocates say that these explosions occur exactly when they are needed. However, the gold didn't sign any contract and doesn't know what it's supposed to do.
Roy wrote:
grok87 wrote:The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers)...
What "hypothetical" risk for TIPS—not related to governmental "fudging" of inflation numbers—showed up in 2008?
It should be noted that the 2008 drop was preceded by a 2007 rise. It was, if you like, a small bubble. It did not much affect anyone who was buying steadily. It only hurt if you placed a large purchase at the top. The drop in 2008 amounted to about about 12%. Certainly something to take into account, certainly an indication that the TIPS fund, VIPSX is riskier than the total bond fund, VBMFX. But not anything to conjure up nightmares. And it is fair to say VIPSX recovered within less than a year and got back "on track."

Image
grok87 wrote:
market timer wrote:Gold [had a real return of]1.04% [per year, 1913-present]...not far from today's 10-year TIPS.
I suspect it is an artifact of the starting and ending points of the time period (1913-present).
1) Maybe they had the same return, but TIPS give a very smooth ride while gold gave a very turbulent ride. 2) Going off the gold standard might count as "an artifact."
Last edited by nisiprius on Thu Aug 26, 2010 7:28 pm, edited 2 times in total.
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Postby letsgobobby » Thu Aug 26, 2010 7:18 pm

Agree with nisiprius.

One would expect gold to have an exactly 0% return over inflation over many many years. Commodities price increase = inflation, after all, unless an actual scarcity were to develop..

TIPS have a positive real return built in. Hold for the duration, and get the real return.

Not much else to say, I don't think.
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Postby Adrian Nenu » Thu Aug 26, 2010 7:36 pm

Gold is a risky asset class.

TIPS is not a risky asset class.

If you want to lower portfolio risk, add TIPS, not gold.


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Postby nisiprius » Thu Aug 26, 2010 8:14 pm

Adrian, I pretty much agree with you, but I'm sure you understand that in theory adding a small amount of an uncorrelated risky asset can lower total portfolio risk.

If you treat gold simply as an uncorrelated asset, and do the efficient-frontier thing just like the slice-and-dicers do, what percentage of gold would be the optimum amount to add to (say) a 60% stocks/40% bonds portfolio? Anyone know?

An off-the-cuff remark Burton Malkiel makes in A Random Walk Down Wall Street refers to 5%, if I am remembering correctly.
Last edited by nisiprius on Thu Aug 26, 2010 8:20 pm, edited 1 time in total.
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Postby SSSS » Thu Aug 26, 2010 8:17 pm

nisiprius wrote:what percentage of gold would be the optimum amount to add to (say) a 60% stocks/40% bonds portfolio?


Trick question! You'd have to lower one of those percentages first or else you can't add any. :o
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Postby EO 11110 » Thu Aug 26, 2010 10:07 pm

bonds/tips is a risky asset class -

gold is not -

imo bonds will get crushed over the next few years -

tips, tied to the cpi = guaranteed loss on the inflation hedge (as cpi understates price increases)
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Postby stevewolfe » Thu Aug 26, 2010 10:38 pm

EO 11110 wrote:bonds/tips is a risky asset class -

gold is not -

imo bonds will get crushed over the next few years -

tips, tied to the cpi = guaranteed loss on the inflation hedge (as cpi understates price increases)


I hear this often but there is actually a substantial amount of information available that suggests CPI overstates inflation as well (due to bias such as substitution, new product, quality, etc). It is not abundantly clear which side is correct and I'd hardly feel comfortable saying CPI understates or overstates inflation as a fact.
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Postby market timer » Thu Aug 26, 2010 10:45 pm

Speaking of risk, nobody buys credit default swaps for gold.
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Postby barefootjan » Thu Aug 26, 2010 10:59 pm

It's like comparing a AA alkaline battery with 5 grams of gunpowder. They are both called "energy sources" (and they both contain about the same amount of energy, 15,000 joules, if I Googled and calculated correctly) but I can't imagine any situation in which they would do the same job.

I betcha McGyver knows a few... :roll:
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Re: 10 year TIPs vs. Gold

Postby grok87 » Sat Aug 28, 2010 9:33 pm

Roy wrote:
grok87 wrote:The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers)...


What "hypothetical" risk for TIPS—not related to governmental "fudging" of inflation numbers—showed up in 2008?

Well you have a good point. What happened in 2008 was 2 things:
1) the real yields spiked-ie. mark to market risk
2) the seasoned tips with high inflation factors sold off the most because the market got spooked about deflation. TIPs with high inflation factors offer less protection against deflation

both these problems are addressed by, as i have suggested, buying at auction and holding to maturity. If you hold to maturity, mark to market risk is irrelevant- you will always get your inflation adjusted principal back at maturity. If you avoid buying bonds with high inflation factors, deflation is not a concern- you are guaranteed to get your initial principal or par back at maturity.
cheers,
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Re: 10 year TIPs vs. Gold

Postby EO 11110 » Sun Aug 29, 2010 12:24 am

grok87 wrote:
Roy wrote:
grok87 wrote:The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers)...


What "hypothetical" risk for TIPS—not related to governmental "fudging" of inflation numbers—showed up in 2008?

Well you have a good point. What happened in 2008 was 2 things:
1) the real yields spiked-ie. mark to market risk
2) the seasoned tips with high inflation factors sold off the most because the market got spooked about deflation. TIPs with high inflation factors offer less protection against deflation

both these problems are addressed by, as i have suggested, buying at auction and holding to maturity. If you hold to maturity, mark to market risk is irrelevant- you will always get your inflation adjusted principal back at maturity. If you avoid buying bonds with high inflation factors, deflation is not a concern- you are guaranteed to get your initial principal or par back at maturity.
cheers,


but your principal will be worth less.

that's the problem with a money supply that is multiplied at will.

the denominator is a variable -- not a number

what's a dollar? answer = undefined
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Re: 10 year TIPs vs. Gold

Postby grok87 » Sun Aug 29, 2010 11:00 pm

EO 11110 wrote:
grok87 wrote:
Roy wrote:
grok87 wrote:The "risk" of TIPs is a hypothetical one (will the US government start fudging the inflation numbers)...


What "hypothetical" risk for TIPS—not related to governmental "fudging" of inflation numbers—showed up in 2008?

Well you have a good point. What happened in 2008 was 2 things:
1) the real yields spiked-ie. mark to market risk
2) the seasoned tips with high inflation factors sold off the most because the market got spooked about deflation. TIPs with high inflation factors offer less protection against deflation

both these problems are addressed by, as i have suggested, buying at auction and holding to maturity. If you hold to maturity, mark to market risk is irrelevant- you will always get your inflation adjusted principal back at maturity. If you avoid buying bonds with high inflation factors, deflation is not a concern- you are guaranteed to get your initial principal or par back at maturity.
cheers,


but your principal will be worth less.

that's the problem with a money supply that is multiplied at will.

the denominator is a variable -- not a number

what's a dollar? answer = undefined

If you buy tips at auction, and hold to maturity, then i don't think your principal can be worth less in real terms (unless the government starts fudging the inflation numbers). One of two things will happen:

1) There is net inflation over the period (i have assumed a 10 year holding period). In that case the real value of your principal is the same- i.e. principal has not lost value. For example if net inflation over the period is 20% and you invested $1000 initially you get back $1200 at maturity.

2) There is net deflation over the period. In this case the real value of your principal has increased since you get paid back, at a minimum, the par or nominal value of your initial investment. For example if there is net deflation of 5% you might think that you get paid back $950 if you invested $1000 initially. You don't. You get your full $1000 back.

Note all of the above ignores taxes...
cheers,
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Postby Adrian Nenu » Sun Aug 29, 2010 11:22 pm

Adrian, I pretty much agree with you, but I'm sure you understand that in theory adding a small amount of an uncorrelated risky asset can lower total portfolio risk


Negatively correlated asset classes lower portfolio volatility not risk. Gold is volatile and can easily drop 50% and no real long term return after inflation and fees. Not so with TIPS or other bonds because they are low risk asset classes and have very low or negative correlation to stocks and positive real returns in the long run. Consider this: the economy can pick up, gold drops but stocks stay flat. At least TIPS offer a real long term return, small as it may be, with minimal risk.

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Postby RobG » Tue Aug 31, 2010 1:37 pm

nisiprius wrote:Adrian, I pretty much agree with you, but I'm sure you understand that in theory adding a small amount of an uncorrelated risky asset can lower total portfolio risk.

If you treat gold simply as an uncorrelated asset, and do the efficient-frontier thing just like the slice-and-dicers do, what percentage of gold would be the optimum amount to add to (say) a 60% stocks/40% bonds portfolio? Anyone know?

An off-the-cuff remark Burton Malkiel makes in A Random Walk Down Wall Street refers to 5%, if I am remembering correctly.


In the 2007 edition of RWDWS Malkiel says that, given the recent price run-up, he finds "it hard to be enthusiastic. But there could be a modest role for gold in your portfolio." He then mentions 5% as a possibility, but isn't too big on it.

The math is clear that adding uncorrelated assets will increase your expected return even if the real return of that asset is zero. So the question is how much to allocate to gold.

Taking a swag an allocation amount... figure it should be less than my allocation of any particular individual stock since those have real expected returns and similar volatility. That puts the efficient frontier amount at less than 1% IMO. Any more than that would be increasing the risk and lowering expected return.... just a swag, but at least it gives a sense of what it should be.

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