The hidden dangers in safe havens

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So what exactly is the "intrinsic value" of a dollar bill or a Treasury bond?

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The Hidden Dangers in Safe Havens

By Paul Sullivan
The New York Times
Friday, August 19, 2011

http://www.nytimes.com/2011/08/20/your-money/the-hidden-dangers-in-safe-...

As Europe's debt troubles intensified earlier this month and United States debt was downgraded, many people rushed into gold and Treasury securities as a safe haven. It was the latest sign that in uncertain times, investors act in ways that can hurt them in the long run.

"They fled the perceived risk of falling stock prices right into the assured risk of overvalued assets," said G. Scott Clemons, chief investment strategist for the wealth management division at Brown Brothers Harriman.

What drove those decisions was not logic but fear -- fear of a repeat of September 2008. And that fear may only have intensified when markets dropped again on Thursday, sending yields on 10-year Treasury notes to record lows and the price of gold above $1,800 an ounce.

... Dispatch continues below ...



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Even if the fear is understandable, however, acting on it may not be the best long-term strategy.

"If you were right about the timing decision to get out, you're going to have to be right again about when to get back in," said Joseph W. Spada, managing director at Summit Financial Resources in Parsippany, N.J. "Even professionals have trouble doing it. If that's not going to be your strategy, then don't do it once."

But now that people have done it once, what are the risks of holding on to large positions in gold and Treasuries?

While the economy may seem bad to many people, it would not take much improvement for investors to lose money quickly on their investment in Treasury bonds.

A week and a half ago, the 10-year Treasury note was yielding only 2.10 percent, after Standard & Poor's downgraded the United States' credit rating. Since the yield of a bond moves in the opposite direction of its price, this meant demand for 10-year Treasuries was high.

If over the next six months, the yield were to move up another half of a percentage point to 2.60 percent, however, investors owning those bonds would have a negative 6.25 percent return, said Barbara Reinhard, chief investment strategist at Credit Suisse Private Banking in New York. If the yield curve were to move up a full percentage point during that time, the loss would be 14 percent.

She said such a quick increase could easily happen, as it did from October 2010 to January 2011 when the Federal Reserve began its second round of large-scale purchases of government debt, the program known as quantitative easing.

Now plenty of people buy bonds with the intention of holding them until maturity. In doing that, it would seem that they would earn a return of 2.10 percent. But they would actually lose 1.5 percent, when the most recent inflation rate of 3.6 percent is factored in.

"That's assuming inflation doesn't rise," Ms. Reinhard said. "Right now, you're betting inflation will fall below 2.10 percent. You're betting against history because inflation has been around 3 to 4 percent historically."

This is not the brightest picture for people who added to their allocation of Treasury bonds. But many felt it was the only safe place.

J.D. Montgomery, a managing director at Canterbury Consulting, an investment consulting firm in Newport Beach, Calif., said he had a client who wrestled with where to put $5 million that he needed to keep safe. The client chose a three-month Treasury note, even though the interest was only $1,000.

There was at least some logic behind this. Most people who bought Treasuries were abandoning their investment strategy, and wealth advisers say that is more troubling than paltry returns.

"The risk of changing your strategy when it's being tested as opposed to changing it when it's not being tested is you risk derailing your long-term investment plan," said Gregg Fisher, president and chief investment officer of Gerstein Fisher, a wealth management firm in New York.

So what should nervous investors have done? Selling Treasury bonds when everyone else was buying them would have been a start. But that might have taken too much discipline. Moving to cash was the top option because at least investors would have money ready when they felt comfortable returning to the markets.

Investors in gold are a different breed. They often have a passion for the metal that goes beyond returns. And they are not going to be swayed by arguments that gold, hovering around $1,800 an ounce, is overvalued.

"When you buy gold you’re saying nothing is going to work and everything is going to stay ridiculous," said Mackin Pulsifer, vice chairman and chief investment officer of Fiduciary Trust International in New York. "There is a fair cohort who believes this in a theological sense, but I believe it's unreasonable given the history of the United States."

As for the nonbelievers who piled into gold, they need to think practically now. Only about 11 percent of gold has an industrial use. While gold can get lost or buried, it does not get used up like oil or natural gas. And its actual cost is between a third and half of where it is trading. Dan Denbow, co-manager of the USAA Precious Metals and Minerals Fund in San Antonio, said it cost about $600 to produce an ounce of gold, but that rises to about $1,000 when all the costs of mining are factored in.

Yet a bigger risk may come from exchange-traded funds for gold. While they let small investors buy gold easily -- the price of one share of the GLD exchange trade fund is roughly one-tenth the price of an ounce of gold -- that same ease of buying means investors can just as quickly sell their shares in a panic.

No one I spoke to would venture a guess as to how high gold would rise before it hit its peak. But most stressed that people forgot that gold’s value was driven by sentiment.

"Gold doesn't have any intrinsic value," said Larry M. Elkin, president of Palisades Hudson Financial Group in Scarsdale, N.Y. "It's this era's wampum. At one point you could buy Manhattan for beads."

(Mr. Elkin said what bothered him the most about investing in gold was how irrational it was, unlike buying a blue-chip stock whose value rises and falls based on what the company produces.)

That said, having gold in a portfolio is still a good buffer against swings in other markets. Mr. Fisher calculated that over a 43-year period ending in June 2011, the average annual increase for gold, accounting for inflation, was 3.82 percent compared with 4.92 percent for the Standard & Poor's 500-stock index. Gold, however, was 28 percent more volatile.

"The smoother the ride, the more likely the investor is going to stay in his strategy," Mr. Fisher said. "That produces a better result."

He said that from the perspectives of both return and volatility, a better strategy would have been to put 10 percent in gold and split the rest 60-40 between stocks and five-year Treasury bonds. Rebalancing the portfolio to maintain those ratios would have meant an average annual return of 4.66 percent, with more than half of the volatility of gold alone.

For those who fled to gold and Treasuries, the hardest part will be deciding when to get back into other securities. The best way in uncertain markets may be to go slowly in small chunks -- a practice known as dollar-cost averaging.

"There are real and psychological benefits to it, because getting someone to take that first step is the hardest," said Christopher Wolfe, chief investment officer for the private bank and investment group at Bank of America. "With a five-year time horizon, it makes a big difference. You might get one of those wicked big down days you could benefit from. But if you have a 30-year time horizon it doesn't matter."

Of course, if people had thought on such a long time horizon they might not have rushed to buy gold and Treasuries in the first place.

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