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, Random Roger (164 clicks)
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A Mr. Richard Feder from Fort Lee, New Jersey writes in and asks:

Hey Roger I have often wondered when there is 3% allocation to gold how does that make it a realistic diversifier (assuming gold has a low correlation to the other 2 classes). You would need 400% move in Gold to give sufficient weight to balance the moves in other classes. I often see mutual funds with this token allocation -- Does it work?

In years past, I wrote frequently about the role of diversifiers in the portfolios I manage. The above question was left on yesterday's post, which included a quick mention of gold and the reader apparently is familiar enough with this blog to know I prefer a low to mid single digit weighting.

So the first point would be to focus on a word in the previous paragraph -- diversifiers. When the market is doing very well, like it has for the last 42 months, the importance of diversifiers will diminish. They become more important when the market is warning of trouble -- I would look at the 200 DMA, the yield curve and the 2% rule for this type of read.

My approach is from the top down, trying to protect the entire portfolio. In the last bear market, we used several diversifiers, including the SPDR Gold Trust (NYSEARCA:GLD), absolute return funds and the ProShares Double Short SPX (NYSEARCA:SDS), along with selling some positions. Each position was targeted in the 2-3% range and grew in relation to the portfolio as things shook out. The combo of diversifiers allowed us, in my opinion, to achieve our goal of avoiding the full brunt of what turned out to be a large decline, while at the same time, not leaving us overly exposed to some sort of unforeseeable calamity in any single product.

Whether it was enough just in gold, as the reader asks, is a subjective thing, but again, not what we were focused on. What we were focused on was trying to minimize the drop in the bottom line dollar figure of the portfolio.

Another point to make is that I still believe equities offer the best long term growth potential, even if that will mean more in the way of foreign exposure. To repeat from past posts, the objective is an equity portfolio that is hedged with diversifiers as I perceive are needed. I do not want a portfolio of diversifiers hedged with a little bit of equity exposure.

In trying to prepare clients mentally for the then coming downturn a few years ago, I frequently said that finding out after a large decline that you had too much in equities is a bad situation to be in. At the same time, there was increasing sentiment in the comments here and elsewhere about putting it all into funds like the ones John Hussman manages. So this sentiment about extremely low volatility funds came after the large decline. Now, the pendulum has swung back such that pundits are advocating buying dividend stocks instead of CDs. Cash that needs to be held in cash probably should not go into stocks, lousy yields notwithstanding.

Hopefully, the theme of consistency comes through in these blog posts. Most of the time, equities do well and it makes sense to maintain something reasonably close to your target allocation most of the time. If you target 60% to equities, then staying close probably means 50-70%, not 20-30%. This, along with reasonable diversification, should keep you relatively close to the market's upside.

If you have in interest in trying to avoid the full brunt of large declines, then I would suggest using objective trigger points that you can stick to. At such a time that the market is warning of a large decline would be the time to consider increased exposure to diversifiers.

By the way, the reader's name is not Richard Feder, and I doubt he is from Fort Lee. This is a "Saturday Night Live" reference from the Gilda Radner years.

Source: Position Sizing Of Diversifiers