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How Dangerous Is Inflation for Your Investments?

As the economy gets back on track, shortages of workers, commodities, things like computer chips have caused both shortages and price increases. There is a fair amount of honest debate about whether or not most of the current bout of inflation is temporary or the start of something prolonged and worse. Assuming that we are entering into a serious inflationary cycle, how dangerous is inflation for your investments? Part of the answer depends upon what your investments are.

Is Inflation a Risk When Investing?

To the extent that your investments give you a set annual return such as with CDs, Treasuries, corporate bonds, or simply a passbook savings account, you will typically find yourself receiving negative real interest rates. The point of saving and investing is to increase your purchasing power in years to come. While these investments will give you a positive return in the number of dollars that you have, those dollars will be worth less when measured in purchasing power. Thus the risk of inflation is that your real net worth when measured by your ability to pay for things that you want or need will be reduced despite steady, diligent investing and saving.

What Are the Negative Effects of Inflation on Investors?

The first negative effect of inflation, as we have already noted, is that interest-bearing investments lose ground in purchasing power. Another negative effect can be less easy to spot. Investors get worried when inflation ramps up and start choosing riskier ways to invest and investments. This sort of behavior includes staying with a stock or index as it becomes more and more clear that a bull market is nearing its end. Or, an investor neglects to rebalance their portfolio as stocks take up a greater proportion. This may make sense in the middle of an inflationary cycle but it leaves the investor open to market risks that having a “cash” portion of their portfolio is meant to protect against.

How Dangerous Is Inflation for Your Investments
Loss of Purchasing Power From 1% Versus 5% Inflation

What Investments Are Safe From Inflation?

Over the years the value of homes and investment property tends to go up with inflation. This is always more pronounced in areas where prices are already higher. The old adage that the most important factors in real estate are location, location, and location applies with greater force when inflation drives prices up. When you are talking about your home, you won’t necessarily sell it and take a profit because you need to buy another and inflation has driven up prices across the market.

What Investments Do Well During an Inflationary Cycle?

Gold is a traditional favorite when inflation ramps up but so are other commodities. In the stock market, technology and consumer goods tend to do well too. A good rule of thumb is to avoid getting into growth stocks whose stock prices are held up by the expectation of futures earnings. When those future earnings are made less valuable in terms of purchasing power, it hurts the stock as well. Vehicles like REITs can do well in these times. And, when inflation is rampant, collectibles go up in price. These include fine art, rare coins, and vintage cars. If you have the knowledge and judgement to make good choices with collectibles they can be an excellent hedge against inflation. But, if you are naïve and make bad choices you will lose a lot of money which in turn will be worth even less because of inflation!

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Strategic Mineral Investments

Another cold war is ramping up. This time it is not so much between the USSR and the West but specifically between China and The United States. Issues for investors at the heart of this struggle for global political, financial, and strategic dominance include strategic mineral investments. High tech and the world of the future demand a set of elements collectively called rare earth minerals. These minerals are found in rocks all over the world but in trace amounts. Mining companies with strategic mineral investments seek out higher concentrations of these valuable minerals and then need to refine them. The ones that do this efficiently will be the most profitable investments.

Does China Control the Rare Earth Minerals Market?

Back in 2010 China exported about 97% of all rare earth minerals consumed by the tech industry. Today that percentage has fallen significantly as other nations are ramping up efforts at mining and extraction. As of 2018 China’s share of global rare earth mineral exports was 46.3% with the USA, Austria, and Malaysia at in the 9% range, Japan exporting 7%, and the rest of the world making up the remaining 23%. Making good bets on strategic mineral investments will require finding the companies doing business in this sector and assessing their ability to make a healthy profit.

trategic Mineral Investments - 2018 Exports

Global Rare Earth Supply Chains

An extensive article in China Power reviews the status of global rare earth mineral supply chains.

As China’s economy has developed over the last several decades, its leaders have sought to transform the country into a key player in strategically important industries. Toward this end, Beijing has established China as the dominant global supplier of rare earths, a collection of 17 minerals that are indispensable to the manufacturing of smartphones, electric vehicles, military weapon systems, and countless other advanced technologies.

The degree to which China has leveraged their position at the top of the supply chain for these minerals is what has worried the West and, in fact, countries across the globe. The Defense sector is especially concerned about relying on China for minerals that are essential to its high tech weapons arsenal.

Strategic Mineral Investments - Defense Applications of Rare Earth Minerals

Potential Strategic Mineral Investments

A US mining operation highlighted in the China Power article is the Mountain Pass Mine. They are the primary US rare earth producer. However, they have routinely sent their production to China for processing! That will change in 2021 as Mp Materials (MP on the NYSE) sets up a refining operation at the mine. MP currently trades for $31.80 a share which is up from $9.60 when it first traded in January of 2020 and which is down from its high of $45.99 in March of 2021.

Strategic Mineral Investments - Mp Materials Mountain Pass Operation

Investments in Lithium Mining

In our article about lithium mining investment issues we noted that mining and processing of lithium for high tech batteries is a similar issue for the USA versus China. As we noted, the USA has sources of lithium via mining operations and brine extraction. In the coming decade and beyond we expect to see successively larger projects to mine and process lithium as well as rare earth minerals in the USA.

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How Often Should You Rebalance an Investment Portfolio?

The stock market continues to climb and bonds remain in the limbo of low interest rates. There is a tendency for an investment portfolio to get out of balance in this environment. How often should you rebalance in investment portfolio? And, for that matter, why should you aim for a balanced portfolio instead of simply aiming for the best-performing investments?

Rationale for Balancing an Investment Portfolio

Investors balance their investment portfolios in order to balance the potential for return on their investments and the risk associated with those investments. The traditional approach is to invest primarily in stocks when you are young and starting out and to pivot towards more bonds, treasuries, and CDs as you approach retirement. An investor in their twenties may have 90% stocks and 10% bonds while someone in their forties might go with 70% and 30%. Traditionally, someone near or in retirement may have half or more of their portfolio in bonds. While the US stock market has historically returned as much as 10% a year on the average, there have been long periods when the market has slumped and remained down for years. The rationale for balancing an investment portfolio is not to get caught during a market crash and slump with no means of support while you wait for the market to recover.

Do You Really Need to Balance a Portfolio?

Warren Buffett has said something to the effect that people only balance their portfolio because they don’t know how to apply the concept of intrinsic value to pick the right stocks over the long term. That having been said, markets still slump and having a part of your investments in cash equivalents helps you avoid having to sell good stocks to live during retirement because the market crashed. Buffett’s suggestion in regard to those who do not have time or expertise to choose and follow the right stocks is to invest regularly in an ETF that tracks the S&P 500. This approach does indeed help avoid the problem of picking the wrong stocks but not the issue of being stuck 100% in stocks when the market crashes.

How Often Should You Rebalance an Investment Portfolio?

If you are going to follow the traditional recipe for allocating investments to stocks and bonds you will rebalance when it is time to change the mix as you get older and when the portfolio gets out of balance because either stocks or bonds have gotten ahead of the percent of the portfolio that you have chosen. Because the market and interest rates fluctuate normally, it is not a good idea to fuss over this issue every month. But, rather take a look and make changes on a yearly basis.

How Often Should You Rebalance an Investment Portfolio

What Is the Best Method for Rebalancing an Investment Portfolio?

A good reason for holding off on rebalancing every time that the percentage varies a bit is that you would need sell your winners and buy new stocks or bonds to re-achieve balance. The best way to get back into balance is to adjust your purchases of stocks or bonds. If you are way ahead on your stock percentage as many investors are today it is time to invest in bonds, CDs, or treasuries until you have returned to the balance that you desire. One can simply use the dollar cost averaging route with stocks or interest bearing investments for this task.

What Is the Rule of 110?

If you are wondering just how much of your investment portfolio should be in stocks versus bonds, treasuries, or CDs, considering using the rule of 110. Take your age and subtract it from 110. If you are 30-years-old the rule of 110 will tell you to put 80% of your portfolio into stocks. If you are 60-years-old the rule of 110 will tell you to allocate 50% to stocks and 50% to interest-bearing investments. Investors have used this approach for decades. It is still in use because it keeps your portfolio from being top heavy with stocks at the end of a bull market when the risk of crash is high. And, it gets you back into stocks as a bear market is bottoming out and you can find bargain stocks for the next bull market.

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How to Profit From the Growth of Solar Energy

The United States Department of Energy has just published their “blueprint” for a huge increase in the use of solar power in the USA from 4% to 45% of the total energy budget. This got us wondering how to profit from the growth of solar energy over the next years and decades. The work necessary to achieve this goal by 2050 would include doubling the rate of installation of solar energy facilities yearly for four years and then again by 2030. To achieve this goal would require an expansion of the electric grid as well. Along with their solar plans the administration wants to increase the number of offshore wind turbines from a handful to hundreds.

Investing in Cheap Solar Panels and More

As noted in a New York Times article about the Biden solar energy plans, solar panels have become cheaper in recent years.

The Energy Department said its calculations showed that solar panels had fallen so much in cost that they could produce 40 percent of the country’s electricity by 2035, enough to power all American homes and 45 percent by 2050.

Getting there will mean trillions of dollars in investments by homeowners, businesses and the government. The electric grid, built for hulking coal, natural gas and nuclear power plants, would have to be almost completely remade with the addition of batteries, transmission lines and other technologies that can soak up electricity when the sun is shining and to send it from one corner of the country to another.

This is the part that got us to thinking about how to profit from the growth of solar energy. China currently produces about eighty percent of the world’s solar panels. Due to tariff issues and concerns about an evolving trade war, Asian manufacturers are moving manufacturing operations into the USA. Five of the leaders are these:

LG Solar
Jinko Solar
Hanwa Q Cells
Sun Power

Sun Power is a US-based company listed on the NASDAQ  (SPWR) and currently priced at $21.60 a share.

Investing in Lithium Batteries to Store Solar Energy

The drawback to relying on solar energy is that there is no power generation during the night. Thus a system that relies on solar needs to have a backup system. This can include wind, hydro, nuclear, and fossil fuels. It can also include batteries that store power during the day and release it at night. In our article about lithium mining investment issues we noted that China currently has the corner on the market for lithium mining and lithium battery production despite the fact that there is plenty of lithium to mine in the Western Hemisphere and specifically in the USA. And, the USA and Europe are both ramping up to produce more lithium batteries that will not be subject to supply chain issues with another pandemic or trade war with China. The biggest lithium battery manufacturers in the USA are these:

Panasonic Energy of North America
LG Chem Michigan Inc.
A123 Systems LLC
Samsung SDI Co. Ltd

EnerSys trades on the NYSE and the current stock price is $75.75.

Investing in companies that make lithium batteries instead of solar panels gives you the advantage of having a foot in solar and wind power as well as the huge surge in electric cars on the horizon.

How to Profit From the Growth of Solar Energy

Clean Energy Payment Plan

One of ways that the Biden administration will encourage electric utilities to allow home solar production into the electric grid is by providing tax credits via the Clean Energy Payment Plan. As noted in the Times article, electric utilities would rather build solar farms where they can control everything than allow homes and businesses to connect to their electric grids. The government hopes to make both things happen with incentives like the Clean Energy Payment Plan.

Investing in Raw Materials for an Expanded Electric Grid

Bringing solar up to the level that the government wants it to be over the next years will require employing and training tens of thousands of workers and will increase the need for aluminum, silicon, steel and glass. One could profit from this surge in demand in commodities by trading commodity futures or by investing in companies that mine, refine, and produce the necessary materials. US-based steel companies include the following:

Nucor, NYSE, NUE, $105.34
US Steel, NYSE, X, $23.57
ArcelorMittal SA, NYSE, MT, $31.93

As we noted in our article about the best investments in solar energy, there are many ways to invest in solar power. With the administration’s push to massively increase solar output in the USA, this subject just moved up on your list of investments to investigate in search of long term profits.

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Investing in Commodities

A common argument for investing in commodities is that doing so allows an investor to diversify a portfolio that consists solely of stocks and bonds. The most highly traded commodities are crude oil, coffee, natural gas, gold, wheat, cotton, corn, and sugar in that order. Commodity futures trading requires a special set of skills and is not what we are talking about when we look at whether investing in commodities is something that you should do to diversify your investment portfolio.

How to Invest in Commodities

There are five basic ways to invest in commodities. You can buy and hold commodities like precious metals as a hedge against inflation or buy and sell over the short term for profit. And, you can invest in ETFs that track commodities like gold which is a more flexible approach than buying and storing gold bullion. Or, you can invest in commodity producers. For example, when the price of gold goes up shares of gold mining stocks commonly go up faster. And, while the most-traded commodity is crude oil there are big oil stocks to invest in. And, like with commodities themselves there are ETFs that track commodity producers like the oil sector or mining stocks.

Investing in Commodities

Investing in Commodities Via Futures

Professional traders trade commodity futures. It is a high reward and high risk trading arena and it is not investing. What some investors choose to do is put money into ETFs or ETNs that track an index which tracks commodity futures. One such index is the Bloomberg Commodity Index. The index tracks contracts on the following commodity futures.

EnergyGrainsIndustrial MetalsPrecious MetalsSoftsLivestock
WTI CrudeCornCOMEX CopperGoldSugarLive Cattle
Natural GasSoybeansLME AluminumSilverCoffeeLean Hogs
Brent CrudeSoybean MealLME Zinc Cotton 
RBOB GasolineChicago WheatLME Nickel   
Low Sulphur Gas OilSoybean Oil    
ULS DieselKansas HRW Wheat    

The index is set up so that no single commodity can be more than fifteen percent of the total and no set of derived commodities can be more than twenty-five percent. And, no sector can be more than a third of the index.

The DJP is an ETN that tracks the Bloomberg Commodity Index. Because it covers 23 different commodities it smooths out some of the volatility of individual commodity futures. Nevertheless, it has lots of ups and downs. And, over the years it has not been a good place to park money for the long term.

Investing in Commodities - Live Cattle

On the other hand, if one had invested in this ETN when the Covid-19 market crash bottomed out, they would have doubled their money by September of 2021. Thus, this investing route works better for short term, in and out, investments.

Why Invest in Commodities?

The point of investing is first of all to preserve your purchasing power and secondly to increase it. Many investors add gold bullion or a gold ETF to their portfolio to counter the effects of inflation. While it makes sense to buy and store gold over the years, that does not work with live cattle, sugar, coffee, or crude oil, all of which have “shelf lives.” “Hard assets” like gold, silver, platinum, or palladium offer inflation protection and tend to move in value contrary to bonds and stocks. Thus, these investments are promoted as ways to diversify portfolio risk. What is not mentioned in that argument is real estate fulfills much of the function and can provide you with a place to live or rent out for profit while also going up in value with inflation.

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Chinese Real Estate and the Next Financial Crisis

The 2008 Financial Crisis and Great Recession started with the mortgage crisis in the USA. Subprime mortgages exploded over the first decade of the 21st century. When “subprime borrowers” were unable to pay and started to default the results in the financial system brought down banks and investment houses. The crisis spread across the globe. Today we are concerned about Chinese real estate and the next financial crisis.

Evergrande and the Chinese Debt Crisis

The Japan Times has a thoughtful piece about how China’s economy is threatened about the debt problems of Evergrande, a huge real estate developer that is in trouble.

Every once in a while a company grows so big and messy that governments fear what would happen to the broader economy if it were to fail. In China, Evergrande, a sprawling real estate developer, is that company. Evergrande has the distinction of being the world’s most debt-saddled property developer and has been on life support for months. A steady drumbeat of bad news in the recent weeks has accelerated what many experts warn is inevitable: failure.

Evergrande, like many Chinese companies, relied on heavy borrowing, the belief that the Chinese economy would steadily grow, and the belief that the government would bail them out if they got in trouble. As China’s debt has grown, the government is cracking down on this behavior. Today it is very possible that Evergrande will not get the sort of bailout that it needs. The ripple effects of this company going under could be substantial for the Chinese economy and for foreign investors who have profited from lending to Chinese companies.

Panic from investors and homebuyers could spill over into the property market and hit prices, affecting household wealth and confidence. It could also shake global financial markets and make it harder for other Chinese companies to continue to finance their businesses with foreign investment. Writing in The Financial Times last week, billionaire investor George Soros warned that an Evergrande default could cause China’s economy to crash.

Chen Zhiwu, a professor of finance at the University of Hong Kong, said a failure could result in a credit crunch for the entire economy as financial institutions become more risk averse. An Evergrande failure, he added, was “not good news to the financial system or the overall economy.”

Debt and the Future of the Chinese Economy

Fortune writes that debt will be a bigger problem than demographics for the Chinese economy going forward. They note that as China ages there will be fewer workers to pay off more and more debt.

Total debt in China represents at least 280% of China’s GDP, according to government figures. If China’s future GDP growth requires the same level of credit growth as it has in the past, then China’s debt-to-GDP ratio must rise to somewhere between 400% and 500%: an unprecedented level of debt, especially for a developing country.
Adjusting for a declining working population makes the numbers even worse. As the working population declines by 0.5% to 0.6% a year, the amount of debt per worker rises by an additional 2% to 3% of GDP every year.

Their point is that China’s debt and growth model is no longer tenable and the time they have to fix the situation is shrinking as the number of workers declines.

Chinese Real Estate and the Next Financial Crisis
Evergrande and the Next Financial Crisis

Chinese Real Estate and the Next Financial Crisis

Every financial crisis has two aspects, the basic problem or problems at its core and the single issue that ignites the crisis. Rising inflation made the ever-increasing debt in the housing market in the USA unbearable. The collapse of a giant real estate developer in China could likewise be the last straw for an over-extended real estate market in China. Investors have lots of things to worry about including the persistence of Covid, extreme weather, the political dangers of investing in China, and now, an increasingly unstable Chinese real estate market whose collapse could spread economic chaos far and wide.

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Investment Risks to Watch Out For

Investing your money always comes with risks. But, leaving your cash in the bank with negative real interest rates means you are accepting a slow and steady decline to your purchasing power. As the stock market has continued its rally in the wake of the Financial Crisis, the chief concern of many investors (and pundits) has been market risk. Have stocks gone too high and too fast? When will be the next crash or correction? There are more investment risks to watch out for and those who are prepared are likely to avoid a lot of pain and suffering along the way.

Important Investment Risks to Watch Out For

Here are nine different risks for investors to be aware of. Each comes with its own level of risk and ways to avoid that particular risk.

  1. Market Risk
  2. Liquidity Risk
  3. Concentration Risk
  4. Credit Risk
  5. Reinvestment Risk
  6. Inflation Risk
  7. Horizon Risk
  8. Longevity Risk
  9. Foreign Investment Risk

Market Risk

Market risk is what most investors worry about. How is the economy going to affect their investments? How will the K-shaped Covid-19 Recession recovery affect their portfolio? Is the VIX telling us that the market is going to crash? The specific market risks include equity prices themselves, interest rates, and currency exchange rates. Interest rate changes have direct effects on bond prices and indirect effects on stock prices. Currency risk has to do with your foreign investments.

Liquidity Risk

One of the reasons that we warn investors about penny stocks is that when you need to sell them there may not be any buyers. In general, the larger the company the more shares they will issue and the more liquid will be their stock. Thus, your investment in a company like Apple, Microsoft, or will less likely to trap you in a stock you cannot get out of than a penny stock that you bought on a tip from a friend and turns out to have been a pump and dump situation.

Concentration Risk

The vast majority of investors do not have the skill set of Warren Buffett who says that if you know which stocks to pick you don’t need to diversify your portfolio. For mere mortal investors, diversifying your investments spreads the risk across market sectors, investment types, and even world markets. In fact, when a recession hits and stock prices fall in the growth stock sector they will go up with value stocks in the consumer goods sector.

Credit Risk

This risk applies to corporate bonds or even government bonds. If a company (or country) is not doing well, has had to borrow money by issuing bonds, and now is stressed because interest rates have gone up and they will have to pay a higher rate when they issue bonds again. To make sure that you will get paid for your investment check the credit rating of the company. You should get higher interest rates for companies with low credit. It turns out that if you pool lots of such junk bonds from lots of companies the higher interest rates more than compensate for defaults making such investments more profitable than bonds with higher ratings.

Reinvestment Risk

When you routinely roll over CDs, reinvest corporate bonds, or use a dividend reinvestment plan you incur reinvestment risk when the original investment is not providing a high enough rate of return. Many investors put part of their money into vehicles like US Treasuries to protect the principal but then accept the reinvestment risk of slow loss of purchasing power of that investment vehicle. In general, younger investors accept more risk and older investors who will soon need the proceeds to live on continue with such investments.

Inflation Risk

Inflation is the loss of purchasing power due to the steady decrease in value of a currency. As a rule of thumb, investors in bonds expect to make enough on their interest to stay ahead of inflation by a few percent. That has been difficult in the last few years. Real estate is usually an investment that protects against inflation as property values tend to go up and rents can be increased to compensate for the steadily decreasing value of the currency.

Horizon Risk

Are you investing for retirement in 30 years, to put your children through college in 20 years, or to start a new business in 5 to 10 years? Which is your investment horizon? Each one has a horizon risk. The long term risk is that you will be in conservative investments too early and forego the profit potential of growth stock. The shorter term risk is that you will get caught in a market crash just when you expected to have the money you had accumulated with your investments. As a rule, investors roll over their risky assets into more-conservative ones as the time comes when they will need money for retirement, kids’ college education, or investment in the business they have dreamed of starting.

Investment Risks to Watch Out For - Longevity Risk

Longevity Risk

When they set up Social Security in the 1930s the average life expectancy was 60 years for men and 64 years for women. Since the age to start receiving benefits was 65, more than half of workers were expected no to live long enough to receive benefits. Today, life expectancy in the USA for a sixty-year-old is 21 more years for a man and 25 more years for a woman. In investing, your longevity risk is that you will outlive your savings, investments, and Social Security. Thus, investors approaching retirement need to balance the risk of a market downturn versus the risks of exiting growth stocks or stocks that pay healthy dividends just when they will start needing that money.

Foreign Investment Risk

Many times the opportunities of investing offshore outshine those of staying in US markets. And, then a new government comes into power, nationalizes all of the foreign companies and drives the country into a depression. Or, your foreign company does OK but the national currency takes a nosedive and takes your investment with it. Foreign investment risk is why many investors stay at home. But, if you want to diversify offshore the options include US-based funds that track foreign regional investments.

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Crypto Bank or Pawnshop?

As noted in a recent article in The New York Times, banking regulators are concerned about companies that offer cryptocurrency loans and deposit accounts (in crypto) with potentially very high yields. Although the goal of the cryptocurrency world is to create a world in which one would never need any traditional currencies, that has not been the case until now. Companies like BlockFi offer deposit accounts, loans, and credit cards all based in cryptocurrency rather than dollars, euros, yen, or pounds. Because you need to deposit cryptocurrency with these folks in order to get loans or earn interest, the State of California raised the question with such company if they want to be a crypto bank or a pawnshop?

What Is a Bank?

In simple terms, a bank is an institution that takes deposits and pays interest, loans money and charges interest, invests to maintain obligatory financial reserves, offers debit and credit card services linked to a customer’s account and has FDIC backing for account categories and banks. Banks in the USA and elsewhere are regulated by the government because of their important role in the economy. And, all accounts are backed by a guarantee by the Federal Deposit Insurance Corporation to $250,000 per bank, per ownership category.

Is a Crypto Bank Really a Bank?

As we noted, companies like BlockFi offer loans, interest-bearing accounts, and credit/debit cards. They do not offer anything like FDIC insurance on their accounts. However, savings accounts can provide returns approaching 90% and there are no background checks for loans as everything is based on how much of a crypto currency is on deposit. Because cryptocurrencies are so volatile there is the potential for huge gains and devastating losses. Some of this potential and risk is lessened by using cryptocurrencies called stable coins which are pegged to the dollar. The biggest difference from a bank is probably the fact that crypto institutions are routinely hacked and there is no protection against loss of all of your assets on deposit.

Crypto Bank or Pawnshop

What Is a Pawnshop?

This question comes to mind because when BlockFi first applied for a banking license in California they were advised to get a license as a pawnbroker. This is because, like a pawn shop, a customer gives the crypto bank cryptocurrency on deposit and then can borrow money in dollars up to half the value of the account. A pawn shop or pawn broker is a business that loans money to people using personal property as collateral. Because BlockFi accepts cryptocurrency and not gold jewelry the folks in California who do pawn broker licenses said BlockFi did not qualify as a pawn broker.

Benefits and Risks of Crypto Banks

The benefits of using a crypto bank include not having to worry about credit checks when you want a loan, having your assets in a “currency” with the potential for exceptional growth, and not having to sell your cryptocurrency and pay taxes on your cryptocurrency profits when you need cash. The primary risk is that someone will hack the bank and take all of its assets. Then you will not have the FDIC protection afforded by a traditional bank account for a bank that goes belly up. Or, your crypto bank may be doing just fine but your cryptocurrency hits the skids and now you have a third of the value in dollars that you used to have just when you need cash.

What If the Fed Starts Issuing Cryptocurrency?

What to do about cryptocurrencies has been the subject of discussion at the highest levels including the US Federal Reserve. Fed Chairman Powell noted that if the USA had its own digital currency you would not need any of the current digital currencies. Because “you cannot fight the Fed” this could be the most compelling argument against banking with a crypto bank!

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Defensive Investing Strategies

The stock market keeps going up despite the Delta variant wave of Covid-19 and the bull market that has been going on since the depths of the Financial Crisis continues. But, as investors keep driving the S&P 500, NASDAQ, and DOW to new records, many are employing defensive investing strategies. Defensive investing strategies are not so much meant to grow your portfolio as to prevent losing what you have gained over the years. Common defensive investing strategies include blue chip dividend stocks, short term US Treasuries, AAA Bonds, diversification across countries and market sectors, and keeping a portion of your assets as cash. Additional measures include trading options to hedge investment risk.

Investing in Dividend Stocks

Companies that have been paying dividends for decades and even more than a century are typically secure investments. When the economy sours, the stock market falls, and investors look for safety they typically buy companies that sell consumer staples, are in the health sector, or have amazingly strong balance sheets. These companies commonly pay dividends as well. If you have put part of your portfolio into a strong dividend stock before a market correction or crash you will typically see a bit of appreciation as other investors pile in later.

Investing with Treasuries and Corporate Bonds

US Treasuries are generally considered to be the most secure interest-bearing investment vehicles followed by AAA corporate bonds. A problem with this approach is that with increasing inflation and interest rates as low as they are today, you are saving with negative real interest rates. Your choices are to use long term treasuries or bonds to get higher interest rates or go very short term and accept extremely low rates. With this approach you will protect your dollars but not necessarily your purchasing power over time. The good part is that if the market does crash, you will have cash to pick up bargains as the market bottoms out.

Defensive Investing Strategies - AAA Bonds

Portfolio Diversification as a Defensive Investing Strategy

Many investors put their money into several US market sectors as well as abroad in order to benefit from where the growth is. Many also diversify in this manner so that investing mistakes in one sector are hopefully offset by growth in another. The best way to do this for most investors is to put your money into one or more ETFs that track the S&P 500, one or more of its sectors, and foreign markets. A problem for the average investor is that they have a “day job” that takes up the majority of their work day. This makes it difficult to adequately follow more than five or so investments. The ETF approach makes this less of a chore.

Defensive Options Trading Strategies

An approach used by professional investors, as well as options traders, to protect stock positions is to buy puts. A put is an option contract that gives the buyer the right to sell a stock at its contract price (strike price) at any time during the duration of the contract. The buyer is essentially purchasing insurance against the stock (or ETF) being taken down in a correction or crash. If the bottom does fall out of the stock price, the put buyer can execute the contract and sell the stock at the strike price even though it may have fallen ten or twenty percent. Alternatively, they can sell the contract to exit and get cash.

Three Versions of Defensive Puts

The basic defensive put strategy is to buy one more put contracts on the stock that you want to protect. Each contract is for 100 shares.  Depending on how much of a loss you are willing to accept before having the put kick in, you can pay quite a bit for the contract or not very much. Assuming that you hold a lot of the stock and that you set your strike price rather high, this can get to be expensive if you continually roll over the contracts to continue the protection. There are two approaches that make this less expensive.

Synthetic Short Stock

If you are certain that your stock is going to fall in price, you can use a synthetic short stock approach. In this case, you buy a put but also sell a call. While the put you sold gives you the right to purchase the stock, the call contract gives the buyer the right to buy the stock from you at the strike price of the contract. You set this up with the same strike price for the puts and calls and the same expiration date. The premium that you receive for selling the call contract will reduce your cost for the trade and may even leave you with a small credit. If the price goes down you can treat this strategy like a protective put and if it goes up the buyer will execute the contract and you will sell the stock for the strike price. Although this approach is cheaper than a simple put, there are a couple of issues.

defensive investing strategies - protective collar

Protective Collar

This approach is the same as the synthetic short stock route but it has two advantages. First, it is cheaper and second, it protects you from selling your stock due to normal market fluctuation. A protect collar sets the put and call strike prices at different levels. The put is much lower than the current stock price and the call is much higher. Since the put and call are out-of-the-money, they are cheap. Thus you can use this approach over the long term if you choose to. And, because you set the strike prices far enough apart, you will not end up selling the stock just because the market fluctuates a little and then see the market stabilize.

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Hedging Your Investments with Index Futures

Investing in the stock market can provide an excellent return on investment over the years. Simply by purchasing shares of the SPY ETF one can match the performance of the S&P 500. However, the stock market, not to mention individual stock prices, can be volatile. Bull markets tend to be followed by bear markets before bull markets re-emerge. One of the ways that you can protect yourself against short term loss is by hedging your investments with index futures.

What Is a Futures Contract?

A futures contract is an agreement entered into via a futures exchange in which the buyer takes on the obligation to purchase a security or commodity asset at an agreed upon price at a future date. The seller accepts the obligation to sell that security on the agreed upon date no matter what the market price is. If a person does not exit the contract before expiration they are obliged to buy or sell as specified in the contract. However, most futures traders and investors hedging their investments with futures exit by selling if they had purchased and buying if they had sold. Because the price of the futures contract will generally have gone up or down, the person will have made or lost money. The point of hedging your investments against loss with index futures is to make money by selling index futures and cover the losses in your portfolio.

How Do You Hedge a Stock Portfolio With Futures?

What stock investors are worried about is that the market will correct or crash and that their stocks will lose value. Index futures are commonly used to hedge against loss in a market downturn.  This is because an index like the S&P 500 moves up and down with the economy and generally runs parallel to a basket of large cap stocks. By selling index futures such as for the S&P 500 the investor protects against a downturn as the futures contract will increase in value if the index falls. Rather than waiting for the contract expire the investor will exit the contract by buying and use the profit to offset portfolio losses.

Hedging Your Investments with Index Futures

What Are Index Futures?

Index futures are cash settled futures contracts on indexes like the S&P 500, Dow Jones Industrial Average, or NASDAQ. Most of these contracts settle quarterly in March, June, September, and December. The futures market trades nearly 24 hours a day with a brief break for settlements six days a week. The S&P 500 futures contract is the most heavily traded index future. The SP contract is the base futures contract for the S&P 500. Multiply the S&P 500 by $250 to get its price. As of this writing, the S&P 500 is 4441.37 which makes the SP contract worth $1,110,342.50. The E-mini future contract is a fifth of the SP contract making it worth $222,068.50. If you choose to trade index futures to hedge your stock portfolio you will need to have money in your brokerage account to cover the necessary margin. In general, the amount needed for margin for futures trading is less that needed for day trading but it needs to be enough to cover your obligations as the market progresses. The CME requires at least $6,300 in maintenance margin for overnight trading of futures and most experts suggest the traders only risk one or two percent of account equity on any given trade.

Is It Better to Hedge Risk with Options or Futures?

Depending on the strategy that you use, both options and futures can add risk to your investment life instead of taking it away. If you are interested in hedging your investments with index futures or options you need to be clear about your strategy, understand the risks, and pay constant attention. If you are unable or unwilling to do this, both approaches can lead to trouble. Because when you buy a call or put option you have the choice of exercising the contract or not, this is commonly a safer route that futures where you are locked into the contract unless you exit at a loss.

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