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Diversifying Investment Portfolios With Gold
Over five decades ago, the “Godfather” of modern portfolio theory, Harry Markowitz, was credited as saying, “A good portfolio is more than just a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” 1
What Markowitz was referencing is now known as the “efficient portfolio,” a combination of investments from various asset classes allocated in a manner that provides a maximum rate of return for each level of risk. As indicated in the Nobel Laureate’s quote, the key to creating these efficient portfolios is to consider investments in diversified asset classes for allocation decisions and, in particular, choosing investments that include different pricing mechanisms, low correlation of returns with other asset classes, and some level of intrinsic value.
These concepts should come as little surprise to all of you loyal readers of the Daily Pfennig® newsletter, as I have shared my views on countless occasions about the benefits of owning a balanced portfolio of various asset classes. However, in addition to the broad Markowitz definition of portfolio diversification, investors can also look at portfolio diversification in a more linear sense, that is, ensuring portfolios are protected and diversified against different types of risk exposures. In addition to the risk of losing money, investment risks can also be defined in more explicit ways that can help qualify how investors can identify and control specific types of portfolio risks.
Diversifying Different Types Of Investment Risk
In the broadest sense, investment risks can be defined as either systematic or unsystematic risks. Systematic risk is the exposure to broader market movements, so it is difficult to eliminate through asset diversification activities, but may be reduced by hedging (purchasing securities that can offset losses in an investment by moving inversely to the original investment). On the other hand, unsystematic or idiosyncratic risk tends to be specific to a certain security or group of securities and, therefore, may be reduced through diversification. To illustrate, individual equities will generally move directionally with the broader market, but each equity will be impacted by company-specific factors that determine how the stocks or industry will perform relative to the broader market.
In addition to broader investment risks, there are also more sector-specific risk exposures for different types of asset classes. For instance, credit and default risks will affect fixed income investors, who may diversify portfolios through the purchase of investment grade bonds or higher-yielding, lower-quality instruments. Similarly, bonds with longer maturities will tend to be more sensitive to changes in interest rates, so investors could diversify these risks with shorter-maturity bonds to protect against higher interest rates.
Foreign currencies investors are certainly well aware of the different types of risk exposures to these types of investments, most notably facing sovereign risks, geopolitical risks, and economic risks. These risks are particularly relevant when purchasing currencies within the emerging market segment, where the allure of higher interest rate payments is generally accompanied by higher potential return volatility. A simple policy statement from one foreign central bank authority can potentially have a widespread impact on the value of a country’s currency.
Avid currency investors are also aware that some foreign exchange securities tend to perform differently in varied markets. Commodity-sensitive currencies, including the Canadian dollar, Australian dollar, and Russian ruble tend to track the commodity pricing complex, while “safe-haven” currencies such as the U.S. dollar, Swiss franc, and Japanese yen tend to perform well during periods of elevated global stress.
One risk delegated to the background, until quite recently, has been the risk of rising inflation on the value of investments, due primarily to the relatively low levels of inflation since the end of the 2008 financial crisis (Figure #1).
Personal Consumption Expenditures, YOY
Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures: Chain-type Price Index [PCEPI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PCEPI,
December 22, 2016.
Higher rates of inflation erode the purchasing power of an investment’s future cash flows, where a dollar today will not be worth (or buy) as much in the future due to inflation. Income generating assets, such as short-term Treasury Bills and long-term Treasury Bonds, tend to be more susceptible to inflation risks over longer investment horizons, and particularly so during a period of exceedingly low interest rates, as experienced over the past decade.2 Higher inflation rates also tend to coincide with higher interest rates, as central banks will raise interest rate levels during periods of accelerating inflation in an attempt to cool economic growth, yet create a double headwind for fixed investments given higher yields (bond prices and yields more inversely) and the reduced purchasing power of future cash flows.
So, why the sudden concern over higher inflation rates? For one reason, it is simply common sense for a properly diversified portfolio to own asset classes that not only provide non-correlated returns relative to other security holdings, but also to own assets that address some or all of the specific portfolio risks facing long-term investors. However, it also appears the winds of change may be starting to blow through the market on account of the recent U.S. presidential election results.
Fighting Inflation With Both Fists
Removing all political commentary for this argument, the fact remains that a single party in control of both the Executive and Legislative branches of government will increase the likelihood that the new administration will be successful in advancing its own pro-growth initiatives. Specifically, the president-elect’s platform for lower taxes and higher infrastructure spending already has economists raising forecasts for growth and inflation in 2017 and 2018.3 Moreover, the equity market’s 6.3% advance since the election is clearly forecasting a period of higher growth and inflation, as performance in equity investments have historically been a reasonable leading indicator for potential growth and inflation (Figure #2).
SPDR S&P 500 ETF Trading
09/23/2016 – 12/22/2016
Source: Yahoo Finance
Gold To The Rescue?
Rather than waiting for inflation to creep into investment returns, investors may be prudent in beginning to reconsider asset classes that provide diversification against these inflation risks. TIPS (Treasury Inflation-Protected Securities) are often the default choice for investors considering inflation protection, which may provide inflation protection for the individual bond, but offer relatively limited inflation protection for the entire portfolio
Instead, investors may want to consider the benefits of gold as a diversification asset class against the risk of rising inflation. To view gold’s performance during periods of advancing inflation, one need only observe the period from July 1972 to January 1980, when the U.S. consumer price index (CPI) increased from 2.9% to 13.9% (Figure #3). During this period, the gold fixing prices advanced from $67 per ounce to $665 per ounce, a nearly 10-fold increase in the price of gold, and well ahead of the rate of inflation.
Price of Gold vs. Consumer Inflation
Source: Gold data – ICE Benchmark Administration Limited (IBA), Gold Fixing Price 3:00 P.M. (London time) in London Bullion Market, based in U.S. Dollars© [GOLDPMGBD228NLBM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GOLD-PMGBD228NLBM,
December 22, 2016.
U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL,
December 22, 2016.
Keep in mind that investments in gold should not only provide diversification against inflation, the shiny metal should also provide other diversification benefits, including low correlations relative to equity markets. More recently, gold has performed more like a hedge given the correlation between gold futures and the U.S. stock market, which reached -0.63 in August 2016, the most negative level ever measured, and indicating a strong inverse relationship between the two asset returns.4 Gold is also a liquid asset class with a clear and measurable store of intrinsic value, which could prove valuable during any catastrophic market event, similar to various types of insurance. Yet, unlike other popular inflation-protected investments and hedges, gold is down 30% from its all-time highs reached during September 2011.5
There is never a bad time to evaluate portfolio holdings, rebalance asset allocations, and determine investment opportunities or protections, given the wealth of “contingencies” investors should steer portfolios against today. In this case, investors may want to consider investments in gold commodities, based on the extensive diversification benefits this unique metal could provide for virtually any portfolio.
Until the next Daily Pfennig® edition…
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