Memory Refresh – Gold’s Role In Diversification

It’s been a discouraging start for the markets in 2016. If you’ve been reading any of Chuck Butler’s recent commentary in the Daily Pfennig® newsletters, you know that investor confidence is down more than it’s up and many individuals are searching for ways to keep their portfolios as sound as possible in view of the slow start to the new year.

Have you asked yourself these questions: Do I worry that my investment portfolio is at risk of a big decline? And does it fluctuate in value more than I’d like? If so, you aren’t alone, and you should be aware of one of Chuck’s favorite potential solutions to explore: gold.

That’s not because gold is less volatile. Sometimes the price is subdued, but other times, it can be explosive.1 And, it’s not because gold is less “risky” than other investments. It fell a whopping 44% from its 2011 high to its 2015 low.2

No, the key to potentially reducing risk and volatility in a portfolio lies in the shiny metal’s correlation to other investments.

Looking Beyond Diversification
Many investors view gold as a “hedge” against inflation, or as “insurance” against some type of economic crisis. While these are valid uses, gold is a potentially good diversifier for another reason.

Readers of the Daily Pfennig® newsletter know that effective portfolio diversification includes not just holding a hedge asset, but one that will zig when most other investments zag. In other words, volatility and risk in a portfolio are not dictated solely by the volatility and risk of an individual investment, but also by how those investments correlate to each other.

This is where gold can come in handy. The World Gold Council has done several interesting studies over the years, and they’ve demonstrated that over the past few decades, gold has a very low correlation to most assets. The following chart (Figure #1) measures the correlation some common investments have had with gold from 1987 through 2012.3

Fig. #1
Assets Correlation To Gold – 1987-2012

Note: A “1” reading means the commodities and gold always moved in the same direction, and “-1” means they never moved in the same direction.

Source: World Gold Council, Federal Reserve, Thomson Reuters GFMS. Used with permission.

A “zero” correlation means an asset will move in the same direction as gold 50% of the time, and move in the opposite direction 50% of the time. A “1” reading means they always move in the same direction, and “-1” means they never move in the same direction.

You can see from the chart above that many common investments have had a low correlation to gold in recent history.

Perhaps surprisingly, investment-grade bonds are not strongly correlated with gold. Even commodities only move in the same direction as gold about two-thirds of the time – meaning they move the opposite direction of gold roughly one-third of the time.

And, stocks have a slight negative correlation, meaning more often than not, they’ll move in the opposite direction of gold.

The benefit of owning gold, therefore, is that it typically doesn’t follow many other investments in your portfolio. This is especially true with stocks. If you expect them to fall, the data shows that gold is more likely to rise than follow them down. This negative correlation is how your portfolio could have reduced volatility and risk.

But first, let’s take a closer look at stocks…

How Many Stocks Do You Own?
Some investors have expressed concern about current stock valuations. They worry about another big correction, or perhaps the onset of a bear market. One way to potentially offset that apprehension is to consider owning some gold.

Recent history bears this out. Here’s how gold has performed during the S&P 500’s biggest declines over the past 40 years (Figure #2).

Fig. #2
Source: EverBank Research Team, based on an analysis of data from Yahoo Finance and Kitco.

Of the eight largest selloffs in the S&P, gold rose in six of them. It declined only twice, one of which occurred right after gold’s great bull market from 1970-1980 (a 2,333% rise from 1970 to 1980).4 And, after the recent 44% decline, the odds are further increased that gold is more likely to rise than fall during the next big selloff in stocks.

Beyond Stock Market Risk
It’s not just the risk of a stock market decline that gold can offset. It can also potentially protect your portfolio against crises that usually have a negative impact on other investments. Depending on your age, you may remember some of these crises, which had varying durations. Notice how gold’s price reacted to each of them (Figure #3).

Fig. #3
Gold Prices During Times Of Systemic Risk

Source: World Gold Council, Federal Reserve, Thomson Reuters GFMS. Used with permission.

 

These crises were all considered low-probability events – yet they all occurred. And, in all but one, the price of gold rose. This action helped offset the losses most other investments experienced at the time. It’s this kind of risk reduction where gold can potentially add value to an investment portfolio.

It’s Not Just The Gold Price
The message from this research is that gold’s benefits are not linked solely to its price. Paying a low price for any investment is always a good idea, but gold has the potential to do more for a portfolio than just return a profit when it’s sold. It may also lower overall volatility, and possibly reduce losses during periods of financial turmoil.

Although past performance doesn’t guarantee future results, you may want to consider how gold has historically had a low correlation to many other assets during periods of high market volatility and episodes of economic crisis, and how that might help you achieve more effective diversification among your investments.

Until the next Daily Pfennig® edition…

Sincerely,
Tim Smith
Vice President, World Markets Sales and Servicing Trader
EverBank World Markets, a division of EverBank
1.855.813.8484
everbank.com