Using Gold to Protect a Portfolio

One of the things people don’t understand about buying gold for diversification is that it doesn’t work all the time.

It works over time.

That means that you can’t simply switch from one asset class to another when the going gets tough and expect miracles. Nor can you expect higher returns.

And that’s the really cruel part.

Many so-called alternative investments, gold being the most notable, are being sold right now on the basis of recent high returns to salivating investors desperate to stop the bleeding in their portfolios.

No question, the yellow metal offers diversification; but near all time highs, its “protection” is debatable at best, when viewed against the harsh light of historical data.

Which is why, at the risk of receiving some very testy email, we have to point out that if you bought gold the last time it was this high, you’d probably regret it now. If you had invested $10,000 in gold in January 1980, the current value of your investment would be $10,600.

Now, compare that to the $279,000 you would have if you had invested that same $10,000 in the S&P 500 Index in January 1980 and you’ll see what I mean.

Does this mean that gold is worthless when it comes to riding out tough markets?

No. Not for a New York minute.

Gold remains a powerful hedge and one that every investor should think about… but for reasons that are not commonly understood.

You see, while gold has never been proven to be a statistically viable inflation protector, it has a significantly correlated 10 to 1 relationship with interest rates and bond prices which, as you know, react to inflation. Therefore, if interest rates rise by 1%, the face value of bonds should fall 10% but gold should rise by 100%.

Which suggests that 10% of the value of a bonds ought to be put in gold… as a hedge.

Here’s how such an example would work.

If we allocate $10,000 to this strategy, $9,000 would go into bonds and $1,000 into gold. If rates rise by 1% (as they’re likely to do and then some), the bonds should fall 10% to $8,100 and the gold should rise by approximately 100% to $2,000. Overall, my portfolio would be worth $10,100 (give or take), which is right about where we started.

That suggests a portfolio of bonds and gold is safer than either bonds or gold in isolation.

Obviously, gold has been bid up substantially in recent months so the 100% rise we expect based on historical patterns may not be as extreme, nor may it rise another 100% from current levels, but the point remains valid - we don’t buy gold because it hedges bad times.

We buy it because gold protects the income stream we get from our bonds… particularly when the economy is facing severe inflationary pressures like it is now.

So how do we make our move and when?

Everybody has their own preferences for gold investing, including us. There are mining companies, bullion, coins and even jewelry. We prefer the SPDR Gold Trust ETF (GLD). There’s no delivery risk, it’s liquid, and you can buy and sell easily through any online brokerage. Plus, as so many residents who lived through Hurricane Katrina found out, you don’t have to worry about Mother Nature or hooligans stealing it either.

As for when to buy, now is probably a pretty good time. The U.S. Federal Reserve has only just begun to acknowledge the inflationary embers it’s been fanning for a long time. And, as usual, they’re dramatically underestimating the 9%-10% we’re feeling in our pockets. So, even if they don’t officially raise rates, odds are that the markets will anyway as traders cope with rising costs on their own.

Though, as you might suspect, there is a downside.

By taking part of the portfolio that would otherwise be placed in bonds and presumably generating income, this strategy dampens the returns we could potentially achieve with bonds.

But given gold’s protective qualities over time, we think that’s a good bet.

Comments

[deuxsous:]

A rare and reasonable approach. Gold for income protection or insurance.

Gold has, however, increased in value (annualized) at about 5.5% per year since 1946 while the US CPI since 1946 has risen about 3.5% per year on average. As you say it is the long run where gold matters in a portfolio.

2008 Jul 09 08:13 AM

[Larry House:]

I have had this strategy in place for some time. Time will tell how well it works.

2008 Jul 09 09:32 AM

[ussmls7:]

I am missing some thing here, if I bought 10K in Fine Gold Bullion in 1980, you said It would only be worth 10.1 K Now? How can you say this? 1980 price at $250 oz =40 ozs = $10,000.00 ! Today Gold Spot = $926.52 oz X 40 ozs = $37,060.80 !!? Also the PPT & a combined effort by I-Banks,IMF,BoE,ECB & the Feds puts, have a main goal of price surpression in Gold & Silver, Gold would be much higher if adjusted for Inflation, so what would 10K invested be if true spot was adjudted to reflect where it should be? 10 to 18% higher!?
That brings us to the reason ETFs , came to be? This new way to play in all sorts of markets,starting with GLD & SLV, SLV has more shares than Bullion to back up the amount of shares,also numbers to not add up,it acts like the Fed,printing money out of thin air,back by nothing, as what it is going on in SLV,selling & tradeing shares,where no bullion exists to back those shares,creating Bullion out of thin air,backed by a paper promise? How can you trade what does not exist,or sell shares that you dont own? These ETFs are in line to blow like the Fed. It seems the Fed likes to make up the rules as they see fit,to protect those whom the Fed works for,not careing how much it destroys this Nation or others that theaten the vast power over all money supplies it enjoys!

2008 Jul 09 11:35 AM

[deuxsous:]

LarryH, Good idea. Gold of course has had and will have bear markets too, but during those times, interest rates fall from initial high rates so bonds will have capital gains.

I'm retired and generate income from investments to live on. Quite conincidentally and independently of Keith Fitz-Gerald, I have had what is now ~9.5% of total invested funds in physical gold for the past ten years, and it works. I have other inflation beneficiary investments too, but 80% is in fixed income.

Most people who love gold these days are short term speculators, and there is nothing at all wrong with that, but Keith's point (and mine and yours) is that gold also works for conservative investors.

2008 Jul 09 02:29 PM

[deuxsous:]

ussmls7,

He may have meant had you bought gold at the $850 high in 1980. He wrote this article and it appeared at his own web site a few weeks ago. Gold was selling as low as 860 basis nearest futures on June 12, so 860/850 was a bit over 1% higher than the high in 1980.

I don't personally like paper gold either except for short term speculation/hedging.

2008 Jul 09 02:39 PM

[User 30121:]

Please check your stats, as USSMIS7, ACCURATELY states, your figures are all wet....and to SUGGEST that investors SHOULD buy ETF's WITHOUT giving buying PHYSICAL PMs equal time is IRRESPONSIBLE! To link the victims of Katrina as reasons NOT to buy PHYSICAL PM's is DISGUSTING...and INACCURATE, too.

2008 Jul 09 06:23 PM