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Gold As Diversification Insurance

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Gold As Diversification Insurance

Insurance is something that you would not do choose to do without. You buy life insurance to protect your loved ones and homeowners insurance to safeguard your home against disasters or accidents. Your investments' safety is also important. How can you insure them against declines in the stock and bond markets?

The answer is by purchasing gold to help smooth out the bumps in the markets over the longer term. Historical investment data demonstrates that the yellow metal performs this function effectively as investment insurance. It is an easy means of stabilizing your returns and risk while lessening the portfolio declines when real estate, stocks, and bonds drop precipitously. The research is clear on this point. When gold is included in asset allocations, it has worked as a capable hedge against risk in investments.

When the stock market is weak for greater amounts of time, gold has increased the total portfolio returns. When the markets are stronger, there has been some little cost for having the portfolio insurance gold. This is as it should be. Insurance premiums for keeping gold in your portfolio for the past 20 or even 40 years have translated to somewhat smaller total returns on the portfolio over a longer time frame.

Some investors might attempt to avoid the long term portfolio cost by purchasing gold when the prices for it are lower and their other investments have not yet declined. The problem with this timing strategy is that no one can say with any certainty how a given investment will do on a multi year, annual, or even monthly basis. It is also true that you can not know with confidence when you will have to cash out and pull back your investment dollars. This time of need could arise after stocks or bonds decline sharply.

Diversification as the Answer to the Dilemma

The answer to the problems of uncertainty with investments is diversification. Through diversification you are able to spread out your risk to a variety of different asset classes. In the most basic form, this translates to having two or more differing investments instead of sinking all of your funds into a single holding. It is only in having a variety of different types of investments that you are able to reduce the unknowns with your portfolio and future money. If you do not diversify, your single investment or asset class could collapse and cost you all of your savings.

Financial advisors tend to favor two simple asset classes in their recommended portfolios. This is generally a mixture of 60%-70% stocks and 30%-40% bonds. Naturally this allocation will change as investments rise and fall. That is why they suggest you rebalance your portfolio on an approximately yearly basis. In this rebalancing, they will have you sell some of what outperformed at the same time that you purchase more of the assets that underperformed. This keeps the stocks to bonds ratio at the 70% to 30% or 60% to 40% ratio you originally established. Not doing this periodically will weaken your diversification and insurance.

A number of these same financial advisors will steer you away from including gold in your portfolio. Their argument is that gold does not yield any income as do bonds and dividend paying stocks. Gold prices have to go up in order for you to realize gains. This difference between gold and equities/bonds also helps to explain why gold prices fluctuate differently than these asset classes.

The Diversifying Power of Gold

Gold possesses five different characteristics that help to explain why it is so effective at reducing risk and stabilizing returns through its diversification. These include:

• Worldwide Demand – Gold has always benefitted from its globally based demand. Central banks, jewelers, electronics makers, and investors all need the yellow metal. Consumer demand rises at certain peaks times of the year in India and China as well to provide it with additional support.

• Positive Bias – Gold prices have a somewhat unique tendency to go up faster than they decline. This is different from stocks. Gold also boasts a negative or low correlation with other investments like equities which helped it to lower the effects of dramatic declines in other asset classes.

• Lack of Correlation – Because gold prices generally move in a different direction from most competing types of assets, this gives it the ability to lower punishing declines of the overall portfolio. When gold is measured against 17 major asset classes from the past five years, it has lower correlations to the other assets than any rivals except for U.S. corporate debt, government bonds and Treasury bills, and the dollar.

• Highly Liquid – Physically held gold bullion proves to be among the most widely traded assets in the world. It would be the fourth biggest foreign exchange pair on the globe if gold were viewed as a currency. The yellow metal trades for nearly 24 hours each day during the business week. This begins in Asian markets and concludes in the United States from Monday to Friday. Some companies also offer live gold trading during the weekend too.

• No Counterparty Risk– Gold is not only traded in dollars. It has a value directly against all currencies in the world. As such it can be bought and sold in any country. This gives it an ideal capacity for defending portfolios from either inflation or severe currency declines.

Gold's Track Record of Diversifying U.S. Investments

Below is a table that demonstrates the results of including gold in in a U.S. based portfolio. This covers aggregate returns including performance and yield. It does not include any taxes, management fees, or transaction costs. A rebalancing is performed every end of the year to maintain a consistent exposure to gold, stocks, and bonds. Equities (as the S&P500 Index) and bonds (as 10 year Treasury bonds) are kept at a 60% to 40% ratio and proportionally reduced as gold is included.

Total Returns (without costs)No Gold5% Gold10% Gold25% Gold
Average 5 Years Annual Returns11.6%11.3%11.0%9.4%
Past 20 Years Compounded Returns7.8%7.7%7.7%7.5%
1976 - 2015 Compounded Annual Returns10.1%10.0%9.9%9.5%
Worst 5 Year Annual Return (2000-2004)2.6%2.9%3.2%3.9%
Worst 1 Year Percentage Return (2008)-14.0%-13.1%-12.2%-9.6%

The table makes it clear that including gold in a basic American stocks and bonds portfolio diminished losses in the worst performance year (of 2008) from the past forty years. It would also have increased returns in the (2000-2004) worst performing five years. As more gold was added, risk became less. At the same time, the rewards were better as the other asset classes did not deliver for longer time frames.

Though there are no guarantees of future performance, gold has insured American portfolios extremely well. In the Tech Stocks Crash, a 10% gold investment insurance holding increased an overall American portfolio return nearly .7 percentage points each year, from 2.6% to 3.2% annual returns. In the worst year of 2008, it would have reduced losses by 1.8 percentage points.

From 1975 through 2015, a portfolio that featured 10% gold would have provided a 9.9% compounded annual rate of return. This represented a lower .2 percentage points each year versus the 60% stocks and 40% bonds portfolio. Even in the very best year 1995 for American stocks and bonds, the 10% gold allocation would have only decreased overall returns to 29.1% from the 32.2%. This makes the cost of having gold insurance quite low for the stability and safety it delivered, particularly in the bad years.

 

 

David Crowder

About David Crowder

W.D. Crowder is an American published author. His background and areas of expertise include history, economics, expatriate living, international relations, investments and personal finance. A widely read and top of his class graduate of Stetson University, he obtained his bachelor of arts degree in History with minors in Latin American Studies and International Relations and a special emphasis in Economics. He was President of his Phi Alpha Theta (National History Honors Fraternity) Stetson University chapter and a Phi Beta Kappa (National Honors Fraternity) member.