Gold for Diversification

Gold is famous for being a haven for investment in times of stock market decline, where investors shed themselves of part or all of their stock positions and reinvest part or all of the proceeds in other investments.

While bonds have been historically a very popular haven for those who wish to liquidate their stock positions to some degree, another popular alternative investment is gold. Gold is thought of as being safer overall than stocks, although a lot of this view stems from thinking about gold too fundamentally and not realizing enough that the price of gold, like the price of stocks, is purely market determined.

Gold and currency, particularly the U.S. dollar, are inversely related, and the stock market, the U.S. stock market that is, is at least somewhat correlated with the dollar. So, it’s not that there isn’t an inverse relationship between stocks and gold, so there is at least some soundness in using gold to hedge stock positions.

Perhaps the best example of this hedge working is during the crash of 1929, where stocks plummeted, while the price of gold rose substantially during this time. During such a sharp decline in the stock market, which didn’t happen in one day but took quite a while to fully manifest, we may rightfully wonder why any sensible investor would not look to move their assets elsewhere, but those who did move at least some to gold were rewarded.

Investments are very often more guided by hope than anything, although the benefits of the flight to gold in such times are better understood today.

The idea of diversification and hedging generally isn’t to seek to make a profit from the hedge, in this case, gold, it is rather to seek to temper one’s losses of the main investment. For instance, if the stock market declines, the hope would be that the hedged position would at least decline at a lesser rate, and preferably, increase in value to make up for some of the losses.

It is true that, given the fact that gold and stocks are not correlated, when stocks go down, and we have allocated a portion of our portfolio to gold, it is less likely that gold will decline as much or more than it will decline less or go up.

With this being true, investors will often take that idea and run with it, holding a certain percentage of their investments in gold as a general diversification strategy. Many money managers recommend investors allocate 3-10% of their portfolio to gold for instance.

Whether this simple approach is ideal or not is another question though, and while the idea of diversification is itself sound and usually preferable, we may not want to use diversification so blindly, with little or often times no regard to the market and the outlook of the asset being used as a hedge, in this case, the gold market.

Movements in the Price of Gold and the Stock Market

There is a prevailing view among many investors that the performance of investments cannot be forecasted in a meaningful way in anything but the very long time period. This is what the investment industry wants us to think at least, even though they spend enormous resources on forecasting markets themselves, and presumably if this were not attainable, they wouldn’t be wasting their time and money on it.

This leads to investors generally not being critical at all when it comes to evaluating their investments, and this is not the ideal approach at all with any investments, and it is true with looking to hedge as well.

If we seek to simplify our hedging strategies though, it may make sense to just view an alternative investment such as gold which has a pretty decent inverse relationship with stocks and then to just place a certain percentage of our funds in the hedge, as a matter of course.

Gold and stocks do sometimes move together as well though, which is a good thing if you are long both, or at least can be seen as such. This may of course serve to dilute one’s returns if the return with the hedge is less, as it often is, and while the hedge itself, protecting us from declines in value with the primary investment, is the main goal here, we still need to look at the effects of the hedge in all conditions.

When both investments decline together, as they sometimes do, then we may benefit from gold declining at a lesser rate than the stock market, meaning that gold has either declined less or has gone up instead by a certain amount.

During long term bear markets, we will generally see gold going up while the stock market has declined significantly, and it is this type of market that needs to be protected against the most, as it can unleash a lot of fury upon those who are fully invested in the stock market and hold their positions throughout these downward cycles.

This does not mean that we should be just holding a percentage of our investments in stocks and a certain percentage in gold or some other hedge, as a matter of strategy. This does involve a strategy, but not one that is really attuned to the market, or what may be expected to seek the best results.

The Best Approach is Always a Variable One

The answer to the question of how much diversification we should seek with an asset like gold is, it depends. It depends on what the stock market is doing, what the gold market is doing, and what other potential hedges like the bond market is doing. There’s also the hedge of keeping a percentage of your portfolio in cash.

Financial markets are not random, and in fact if they were, there would be no point investing in the markets at all, as the expected return would then be zero less trading costs. We know that financial investments do tend to grow in value over time, generally speaking, and this includes both stocks and gold.

Along the way, these investments do follow distinct patterns, where their movement may be predicted to some degree of accuracy. We may look at fundamental analysis, technical analysis, or a combination of both to seek out these forecasts, but the markets can be forecast with a higher degree of certainty than just randomness in any time frame, not just in the long run, and generally with a significantly higher success rate than just randomness.

When we seek to use a general hedge, to hold gold for instance as insurance against a decline, this isn’t really the most efficient way to diversify, as we will require more or less of this protection depending on market circumstances.

If the stock market is bullish, like it was between 1982 and 1999, spanning almost two decades, it would make much more sense to require less diversification than it would during the previous bear market, from 1965 to 1981.

During the aforementioned bear market, you couldn’t hedge too much, and during the following bull market, any hedging you did would have been excessive. In the midst of these markets, one cannot predict how long that these markets will last with any certainty, but certainty isn’t required.

One only needs to realize what type of market we are in with a given investment, and this part isn’t that difficult to ascertain.

If we’re looking to diversify our risk exposure to a certain asset class like stocks, by investing in another asset class like gold, which has a good inverse correlation, the extent that we utilize this strategy needs to be in accordance with the amount of risk we’re looking to offset at any given time.

The Ideal Approach to Using Gold to Diversify

If we look at the most recent cycle with both the stock and gold market, between 2009 and 2017, see that gold has made a small gain during this time, going from about $1100 an ounce to $1280. When your hedge goes up and the primary investments go up as well, this can be seen as a good thing to be sure.

The stock market in general though has tripled in value over this time, so it’s not as if we made money from this diversification overall. What is lost is the opportunity cost, where if we had all of our funds in the stock market, we would have made the most money.

When we look at long term charts like this, it is helpful to take inflation out of the equation, to be able to view the performance of the investment more purely.

We can’t just pick the tops and bottoms in real time like we can when we look back upon charts from the past though, but that isn’t really needed, as trends become obvious enough on monthly charts after they have manifest themselves over a little time.

It is not unreasonable to have a certain amount of your portfolios in other asset classes, as this does protect against unforeseen market risk, and by the time a trend becomes evident enough, this may already involve substantial losses.

Investors tend to hedge too little at the best of times though, and tend to be too exposed to market risk both before and after trends are firmly established.

Risk management is central to portfolio management and this involves considerably more than just diversifying your stock positions to spread out company or sector risk, as this leaves you unprotected against the biggest threat, market risk.

The biggest opportunity to protect better against this risk is to focus much more on diversification with an asset such as gold when the need arises, when the outlook for your investments really starts to dim, and at those times, it can make sense to even completely shift your investments out of the stock market in favor of investments such as gold.

While gold may not perform anywhere near as well as stocks do during bullish times, stocks can also decline by a lot as well, and during these times, having less of your money in stocks is obviously preferable.

Where the gold market is trending matters as well though, in seeking to shift funds, and ideally we are paying well attention to trends in both these markets as we seek to decide how to best allocate our portfolio under the conditions of the day.

To the extent that we are willing to manage all of this, we will at least be seeking to achieve the desired goals of diversification, which is never a one and done thing, it does require both thought and active management.