Precious Metals and the Principle of Diversification; The Good and Bad Reasons to Hold Gold
There has been a lot of fuss about gold investing in the news lately. The situation in Syria coupled with a relatively low price per troy ounce has led many investors to believe that now is the best time to buy gold. History has taught us that paper currencies and traditional investments such as stocks and bonds perform very badly in times of economic and political turmoil. Gold and silver tend to do better in such scenarios.
While there are certainly a lot of good reasons to invest in precious metals, there are also some bad ones. In this article I'll go over the basics of what a good investment strategy is, and how gold can fit in a well balanced portfolio.
Technology and Modern Investing
There are basic principles and concepts behind the science and art of investing and financial management that have been around for centuries. Gaining a basic understanding of and applying these and related principles proved the historical basis for successful investment of one’s capital. A few of these concepts include:
- Preservation of Capital
- Risk versus Return
- Ensuring a Return On and a Return Of Capital for any investment
- Time Value of Money
- Compounding Returns
- True Value is determined by actual Purchasing Power
There is, however, a new principle that is now applied to what is called Modern Portfolio Theory, or MPT. The importance of diversification was theoretically proven by Harry Markowitz in the 1950s. It took the power of modern computers to prove this theory and by the late 70s put it to use in portfolio management. The impact of this issue of diversification is so significant it earned Markowitz a Nobel Laureate in 1990.
Applying Principles to Your Portfolio
While there are four basic components of Markowitz’s concept, the core message is that every investment portfolio should be managed around a diversified collection of assets that have proven reactions to certain market and financial conditions. In other words, some classes of investment move in opposite directions based on whether the market cycle is up or down. The goal of diversification is to optimize a portfolio by protecting against large losses and ensuring gains regardless of market cycle movement.
With this concept of diversification in mind, there are certain what might be called sub-principles that can be applied to individual classes of assets, such as securities, bonds, real estate and precious metals. The include, for example,:
- Bond and commercial debt instrument prices decline as interest rates increase
- Securities generally rise in price with increases in interest rates
- Precious metals rise in value to maintain purchasing power during times of inflation
- Real estate that is leveraged can be a wise investment during times of inflation and challenging during high interest cycles, particularly if the leverage is variable.
As these few examples show, each type or class of potential investment has expected advantages and disadvantages in certain market conditions. Since market cycles are an established financial fact of life, wise portfolio management seeks to capitalize on these advantages and mitigate the disadvantages.
Precious Metals as an Investment: Reasons to Buy and Hold
One investment that has thousands of years of observable investment history is precious metals, particularly gold and silver. Culturally, American citizens don’t have the traditions of Europeans and Asian peoples that see these investments as the surest way to provide protection over the long-term and in difficult financial times. During times of war, invasion and unrest there is a long habit of these people transferring everything possible into gold or silver coins and bullion.
The single greatest value of gold is its historically-proven ability to preserve value. One of the most significant investment data points is that the amount of gold it took to buy a fine Roman toga, a medieval knight’s suit of armor or a top-quality business suit today has remained constant. In other words, while it might take 20 nickels today to buy the five cent candy bar of our grandparent’s time in the 30s, the same amount of gold from 1930 would buy a comparable bar today.
In times of inflation, the ability to protect, or hedge, against a loss of purchasing power is essential to any investment portfolio, particularly individual portfolios with a long-term goal of providing for retirement (IRA, 401k). Reasonable amounts of precious metals are transportable, independent of government actions (such as devaluation) and are universally seen as an excellent medium of exchange.
Aside from its traditional role as an investment and adornment, today’s precious metals are increasingly in demand for industrial applications in everything from technology to medical and specialty products and devices. This is one factor involved in pushing gold prices up to historic levels.
Precious Metals as an Investment: Reasons to Avoid
It is important to note above that the term used is “buy and hold.” For all its many advantages and historical preference as a personal investment, precious metals, especially those such as palladium, are not the right class for all individuals at all stages of life. Precious metals do not produce periodic dividends and, in most cases, are not considered an investment with near-cash liquidity. Additionally, these metals have to be stored and protected from theft.
While there is an active market and global exchanges that deal with precious metals, they are not appropriate trading instruments for the average individual investor.
What Lies Ahead
Aside from the growing demand from industry, there are a number of reasons investors are increasingly turning to precious metals as an integral part of their investment portfolios. Worldwide financial and political issues almost unanimously point to a coming period of increased uncertainty and instability that will almost inevitably mean increasing inflation and interest rates. Governments continue to print money to finance deficit spending with no regard to underlying principles of financial stability of their currency.
Individual investors today must take the time to carefully plan their portfolio in light of current financial and market trends. Most careful evaluations indicate that precious metals are an important element in any long-term, diversified portfolio.