Holding Silver and Bonds for Diversification Purposes
Investors love to diversify, and will do so rather indiscriminately, whether it makes sense to do so and to what degree it makes sense. Diversification is promoted as an end in itself, with little or no regard as to the why, and in particular, what we are seeking to accomplish with this diversification.
What tends to happen here is that investors will hold certain percentages of their portfolios in something like silver or gold, or bonds, as a means of looking to smooth over their equity curves. This results in giving up a degree of potential returns, because we know that stocks produce the best long term returns of the three categories, stocks, bonds, and precious metals.
What is being sought as a benefit from paying this price is having your portfolio experience less volatility overall, and it’s not the limiting of the upside we’re after here of course, even though that happens, it’s the limiting of the downside that is being sought.
Investing a percentage of your portfolio in bonds will accomplish that, and bonds are stable enough that one can do this without a lot of worry about losing a lot of money on the bond investments over the longer term, provided that the interest rate market doesn’t go too crazy.
Investing in silver is nothing like that though, and while silver does move in opposite directions with stocks a lot of the time, silver has a life of its own, and silver can move a lot in a relatively short period of time.
Just investing in silver randomly like people do with the bond component of their portfolios really doesn’t provide a lot of protection against volatility, simply because this may balance off losses from stocks or it can add to them. Well timed adventures in silver is a different matter, but just buying silver with no regard to market conditions and just using this to add stability to one’s stock market holdings makes nowhere the sense that doing this with bonds does, even though that’s not the ideal approach to bonds either.
To sum this up, if we’re going to take random positions in either bonds or silver, the stability of bonds will lend itself much more to this strategy than doing this with something like silver, which is even less negatively correlated with stocks and is much more volatile than bonds.
Among the three types of investments, bonds are most suited to a random investing approach, stocks are fairly suited but due to their ability to move down over extended periods, less so, and silver would be the least suited, due to its larger excursions to both the upside and downside, which aren’t necessarily correlated with either market.
If we are using something like silver to hedge against downturns in stocks, we do need to be much more careful in managing our silver investments to best ensure that we may expect a profit from these investments, and use this profit to offset losses in our stock positions. Just holding a certain percentage of our portfolio in silver or any other precious metal lacks the proper management needed to make this move work over the long run.
Looking to Protect Against Inflation with Silver and Bonds
While there is a fair bit of speculation that goes on in the bond market, individual investors really don’t speculate on them, and they are held simply to look to dilute one’s risk exposure or to earn income once one has saved enough that this becomes a good option.
Once again, silver and bonds both provide a degree of protection against inflation, but with silver in particular, this protection is very long term, and not the sort of thing that tends to manifest itself over a period of just a few years.
If one invests in bonds and looks to earn income over the next few years, and we experience inflation, the value of their income streams will significantly deteriorate, and it may turn out that this may be the worst move they could make as far as looking to protect themselves against inflation goes.
Stocks do not really require inflation protection, and to the contrary actually, as we could even say that nothing outpaces inflation like stocks do. The time frame that we are looking at in all these cases is the longer term though, this is the time frame that both bonds and silver keeps up with it, and stocks exceed it.
Bonds keep up with inflation based upon their current prices, but people buy bonds by locking in certain static rates that are subject to inflation risk. This is the case with things like certificates of deposit as well, you lock in the rate of the day based upon the inflation outlook of the day, and if inflation goes up, you lose, and if it goes down, you win.
Bonds are therefore not really hedges against inflation but bets based upon future inflation rates, as more inflation generally means interest rates will go up, and more inflation also means that the value of your interest payments are worth less dollar for dollar in the future.
Silver, on the other hand, really doesn’t approach inflation directly at all, even though we may think that holding something like silver will be independent of currency devaluations in a meaningful way.
Sure, if the dollar becomes devalued due to inflation, and all other things are equal, silver will provide a hedge against this. The problem with this idea is that all other things are seldom equal, and these other things are what drive silver prices both up and down, and to a significant degree.
We could call this the market risk of silver, and the market risk in this case generally well surpasses any concerns about inflation. The only thing that really influences prices is supply and demand, and if the only reason people bought or sold silver was to hedge against inflation, this model would work, but this is far from the case.
Silver, in fact, undergoes big swings in both directions that are quite independent of changes in inflation rates, and whether or not your silver investments kept pace with inflation over even a period of 10 or 20 years will depend almost exclusively on the state of the silver market during this time regardless of how inflation has moved.
This is not to say that there is no correlation between silver pries and inflation, but the correlation is nowhere near enough to rely on substantially in deciding whether to invest in it or not. Inflation has been increasing over the last 5 years or so, and during this time, the price of silver has given back two thirds of its value, to cite a recent example.
Speculating on Silver and Bonds
Bond speculation is pretty much limited to traders, and the main function of bonds is to provide a means for people to invest over the longer term, at least where individual investors are concerned.
While all investing involves speculation to some extent, we can say that the main purpose of bonds is income generation, not price speculation. The main degree of speculation involved with individuals investing in them is speculating on whether or not the bonds will default, and aside from that, they just look to earn their interest payments over the time that the bonds are held.
People do speculate with stocks though, hoping that when they sell them they will have realized enough of a capital gain on them, in other words, the price of their stocks will have risen enough over the holding period to provide at least an acceptable return on investment.
Silver is clearly in the category of speculative plays, and if anything, even more so than with stocks. Without the benefit of the tendency toward long term capital gains that stocks have, the speculation with silver needs to be over a shorter duration of time, which will require that we successfully time the market to succeed.
One may make money from silver out of sheer luck, with random entries and exits that just happen to match up well with silver’s performance over the time that it is held, but while chimps may be able to invest in stocks long term, they will not do anywhere as well with silver long term by just using random entries and exits.
Bonds are on the other end of this spectrum, and if one buys what are considered to be risk free bonds, such as U.S. treasuries, they know exactly what return they will get over the life of the bond, and short of the U.S. government going bankrupt, they are guaranteed these returns.
Once again, we see silver and bonds on opposite sides of the spectrum, where bonds offer the highest degree of certainty for a certain return, while silver may offer the lowest degree of certainty, depending on how we use it.
This is why random investing in silver isn’t that great of an idea, however if we pick our spots well, silver has the ability to produce returns many times higher than bonds do and even higher than stocks tend to over certain periods of time, especially when stocks are in a bear market.
It isn’t a matter of which we will go with to diversify our stock positions, silver or bonds, it’s more like what proportion should we be keeping in each, depending on overall market circumstances and especially the performance of each market we are considering, the stock market, the bond market, and especially the silver market.
If we can confine ourselves to using a more dynamic form of diversification which allots the degree of this diversification according to the circumstances, we can really use this as a tool to both increase our returns over time and decrease our risk as well, and be much happier with our results.