By Dr. James M. Dahle, WCI Founder
Some people like to use a small portion of their portfolio to hedge against things like hyperinflation or combined terrible stock, bond, and real estate performance. I'm not one of those people, but I don't think it is unreasonable to use 5-10% of your portfolio for such a purpose.
The word “speculative” has a negative connotation to it, like the asset is in a bubble and the speculator is a fool. However, the way I use the word is purely descriptive. A speculative asset is one that does not produce earnings, interest, rent, or income. Yes, you may be able to borrow against it. Yes, there may be some use for it that does not rely on speculation. For example, gold can be used to build satellites, you can hunt on empty land, and you can transfer money from one African country to another in a cost-effective way using Bitcoin. But the main financial purpose of each of these assets is to speculate—essentially to bet that the price will go up. Don't kid yourself that any significant number of people are adding gold or Bitcoin to their portfolio for any other purpose. Speculative assets, by their very nature, are difficult to value at any given time since there is no future income/earnings stream to use to calculate the value. Naturally, every investment (such as a stock) has at least some small speculative component, but that generally makes up only a tiny part of the return of the asset in the long run. With a primarily speculative asset, the speculative component dominates the return, even over long periods of time.
If you are interested in adding a hedge to your portfolio, these are the speculative assets I think you should consider.
Examples of Speculative Investments
The best part about gold is that it has a long, long history. People have been using gold as an investment, currency, or store of value for literally millennia. There is only a limited amount of it on the planet and new gold is only being found/mined so quickly. Gold doesn't rust, leak, or degrade. While it can be somewhat volatile, its long-term returns are well known. Essentially, over the centuries, it keeps up with inflation. The only time in history where that really changed was in the decades after the conquistadors hauled a bunch of gold out of the Americas back to Spain, launching a pretty severe bout of inflation in Europe.
The downside of gold is that it must be stored, protected, and insured.
#2 Empty Land
I don't consider income-producing real estate to be a speculative asset. It can be valued. But land that just sits empty? That's a speculative asset. Maybe it's an empty lot you buy in a town where lots of people are moving in. Maybe it is some land on a stream that is currently 10 miles out of a rapidly growing town. Maybe it's land on which you hope to find oil. Either way, if it doesn't produce income, it's a speculative investment. I'm not talking about farmland or timberland or land with known gas or mineral reserves here. Those have a predictable income stream associated with them. I'm talking about land that just sits. The part I like about this investment is that they're not making any more of it and it is by its very nature an inefficient market. Your knowledge of a local area and its trends can result in solid profits. Likewise, if your knowledge and skill is lacking, your returns may be poor. It is also a very “real” asset in that you can drive to it and walk through it and feel the dirt between your fingers. That's not the case with all speculative assets.
The downside of empty land is that it must be insured and taxes must be paid on it.
The best part of a cryptocurrency investment is that your returns may be absolutely spectacular. If the cryptocurrency you invest in actually becomes the de facto currency in the future and you got in on the ground floor before anyone else had heard of it, you could literally become a billionaire with an investment small enough that losing it all won't affect your financial life. This lottery ticket aspect has clearly motivated a lot of people to add this to their portfolio in percentages consistent with a lottery ticket like 1%. It's fascinating to watch people justify this speculation as though it is anything else. It isn't, but that doesn't necessarily make it wrong so long as you limit it to a small part of your portfolio. Other big advantages of cryptocurrency are that it is easy to hide, easy to transport, need not be insured, and is taxed at capital gains rates. (Gold, for instance, is taxed at the higher collectibles tax rate.)
There are several downsides to cryptocurrency as an investment. It can be lost (something like 20% of Bitcoin has already been lost) and new cryptocurrencies can be invented at any time. But the main downsides are its incredible volatility and the fact that its future returns could be absolutely terrible. It is obvious to the impartial observer that not all 4,000+ cryptocurrencies that have been invented so far are going to stand the test of time. A few decades from now, most of those are going to be worth nothing.
#4 High-End Art
Art is a favored speculative asset class, particularly for the well-heeled. The most expensive art tends to appreciate at a higher rate than the more commonplace art. Quoted returns are often in the 5.3-7.5% range. You can buy the art directly at auction or buy through a private art fund. It can be stored in freeports to minimize taxation as well. While some may derive some pleasure from viewing and showing off their art, most high-end art is not on display in a museum or anybody's home. It's in a climate-controlled, secured facility, probably in a freeport warehouse.
The downsides of art are primarily the costs of storage and insurance. Transaction costs are also not insignificant.
#5 Oil, Gas, and Other Commodities
I'm not talking about an oil and gas producing business or property. I'm talking about the black stuff itself. Southwest Airlines has a great reason to buy a bunch of oil to hedge against their future costs. I'm not as convinced that you and I do, but there are a number of ways to invest in these commodities such as the futures market.
The main risks of commodity futures are twofold. First, it is difficult to be an expert in the market so you are likely to be trading with someone who knows a lot more than you do about it. Second, you might actually have to take delivery without anywhere to store the liquid and then be forced to pay through the nose for storage.
Ahhh…Silver. Get worse returns than gold with more volatility. The one advantage it does have is that there are far more industrial uses for the metal, but that doesn't seem to have made it easier to value or less volatile. I have no idea why someone would want silver over gold as a long-term holding. The only argument I've ever seen to buy silver over gold involves a particularly high gold to silver price ratio, suggesting that the relationship must revert to the mean in the future.
Lots of Bitcoin fanboys like to pretend cryptocurrencies are currencies, as if that provides them some additional legitimacy. They're not, but that's not necessarily a bad thing. There are tons of scams associated with the Foreign Exchange (FOREX) markets, but if you need to hedge against currency changes, putting some of your cash or other investments into a foreign currency can be a great way to do it. If you own international stocks, you're already doing this to at least some extent. If you are working in the US but plan to retire in Italy, Iran, or India, it wouldn't be a bad idea to keep some money in those currencies to hedge against a dollar decline.
The downside of currency investing is, primarily, the hassle. The volatility usually isn't terrible, although there is no guarantee that even in the long run any given currency will keep up with the dollar.
Speculative Assets: The Bottom Line
If you choose to hedge your portfolio using speculative assets, limit how much of your portfolio you put into it. While 1% is probably better termed “play money” rather than a hedge, putting more than 5-10% of your portfolio into assets that don't produce earnings, interest, or rents may keep you working longer than you really want to all while having to manage a more complex and more expensive portfolio along the way.
What do you think? Do you include speculative assets in your portfolio? Why? Which ones? Why did you choose that one? How much of your portfolio have you dedicated to it? Comment below!