From The Vault: The Special Case For Gold

October 24, 2008

 

What Place Should It Have In My Portfolio?

Holding gold as a strategic asset can help you diversify your portfolio.

A long-term asset portfolio needs to be diversified. Diversification helps reduce both risk and volatility. The key to diversification is a choice of assets with returns as little correlated to each other as possible. Essentially, each of your asset classes needs to march to a different tune: Movement in one should be reflected as little as possible in the movement of any other.

Since there is little correlation (it is, in fact, low to negative) between the returns on gold and on financial assets, such as equities, gold can help provide just such diversification (i.e., when financial markets fall, the price of gold tends to rise, and vice versa).

Recent research5 into the difference between gold and other assets has demonstrated that, in the long term, there is no important correlation between changes in inflation, interest rates and GDP and the returns on gold. In contrast, such macroeconomic variables are strongly correlated with returns on such financial assets as bonds and equities.

The same research has also shown that changes in such macroeconomic variables have a much greater effect on the returns on other commodities (particularly non-ferrous metals and oil) than they do on gold.

A general market decline, therefore, will not be reflected in a general decline in the price of gold. Gold will, in fact, provide protection against such declines.

In addition to reducing risk, improving a portfolio's diversification will also help to reduce its volatility. Reducing its volatility will, in turn, often result in higher compound rates of return.

While it is more usual to look at different asset classes when building a portfolio, in the case of gold, it is certainly worth considering it as an asset class in and of itself (rather than as an individual security within the commodities asset class) and, consequently, investing in it directly.

How much gold you should add to your portfolio, however, will depend upon the risk profile of your portfolio. If, on the one hand, you have a low-risk portfolio, the inclusion of gold can help enhance its performance. On the other hand, if you have a high-risk, high-return portfolio, gold's strong lack of correlation to the equity and bond markets could help bring stability in times of either economic turmoil or falling markets.

 

Conclusion

Since timing the market is impossible and your investment in gold is for the long run, the important thing - many people believe - is that you buy it, not when you buy it.

While the recent surge in gold prices has brought speculators into the market, and has increased the short-term correlation between equities and gold, it has done little to rattle the long-term position of the metal as a good portfolio diversifier and a safe store of value.

 

NEXT UP: Base Metals

Precious metals are pretty, but base metals are where the real action happens.

 

ENDNOTES

1. Harmston, S. (1998) Gold as a Store of Value, London, World Gold Council.
2. Capie, F., Mills, T. & Woods, G. (2004) Gold as a Hedge against the US Dollar, London, World Gold Council
3. Kavalis, N., (2006) Commodity Prices and the Influence of the US Dollar, London, GFMS Limited
4. Greenspan, A. (1966) Gold and Economic Freedom, The Objectivist.
5. Lawrence, C. (2003) Why is gold different from other assets? An empirical investigation, London, World Gold Council.

 

LINKS FOR MORE INFORMATION
Doug Casey: The Case For Gold
Resource Investor
Gold Investing 101

 

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