Should gold be in your portfolio?
One of the world’s oldest investments, gold, has been getting a lot of attention lately. Of course, gold is very appealing to look at, and it’s pretty easy to envision gold is a status of wealth and power. Temples and palaces are adorned in it and who can think of Fort Knox without imagining tons of gold bars stacked up in a super secure vault?
Gold has been recognized as currency around the world for thousands of years, but even with all of its publicity lately, is it something that’s worth adding to your portfolio? That’s what I’m going to talk about today, and while it’s not my place to make recommendations in a format like this, I’ll do my best to give you enough information so you can decide what’s in your best interest.
Unfortunately, I found that there is no perfect investment. Everything has a series of burdens and benefits you have to analyze. Plus, there’s also the need to understand the relationships that some investments have with others and what correlations they have to each other as financial markets move up and down.
The truth about gold Historically, gold has been a very popular investment for some and a vehicle people have used to provide themselves peace of mind when it comes to securing their financial future. Because gold is universally accepted as a unit of stored wealth, most people think that by having gold, they will always be in a position to trade it for whatever they may need regardless of what happens in global economies.
That may or may not be true in a practical sense, because it’s probably a little difficult to shave off some gold at the grocery store when you need to reload on milk, bread, and a dozen eggs or so. Either way, gold has really ingrained itself in some people’s minds and hearts as an essential piece of their financial puzzle. But, is that thought process based on emotion, preference, and psychology or is it based on the fact that gold has been a solid performer in terms of building wealth over the years?
Because gold is a metal and not an investment like a company, for example, that produces some form of output and generates a stream of income through cash flows, gold’s only intrinsic value is linked to people’s opinion of it and their desire to hold it. These opinions and desires have fluctuated a lot over the years and that has made the price of gold fluctuate wildly at different points in time. These fluctuations have created periods of rapid growth followed by periods of devastating decline. And, when you analyze gold’s performance over an extended period of time, say like the last 100 years or so, the rate of growth in the price of gold over that time has been less than spectacular. In fact, outside of holding cash, which may or may not be considered a long-term investment, research shows that gold has underperformed every other asset class over the last 100 years. That means that bonds, stocks, real estate, and pretty much any other investment you can think of that’s been around for a while has done a better job of building wealth and growing in value than gold has.
Most people understand that there’s a relationship between risk and reward and is okay to take a lot of risk if the reward is there. High risk levels usually mean higher levels of volatility in the price of any particular investment, and gold has certainly been volatile. The problem is without any ability to determine future value based on earnings or future cash flows, gold’s future price is merely a matter of speculation. Plus, in periods where gold is declining in value or during times when the price of gold isn’t really changing, there’s no income through dividends or interest to compensate you for your patience in holding it. That cannot only create financial losses, but there’s often a very expensive opportunity cost involved with committing your assets to something like that.
Is the tide turning?
So far you may be thinking that it sounds like I’m not a very big proponent of gold. Well, over the past 25 years I’ve been a financial professional, that’s definitely been the case. However, I’ve found it pays to be open-minded and aware of trends and situations that present opportunities to potentially increase your investment returns without taking on a significant amount of risk to do so. I feel that gold may be in that position right now, so let me talk a little bit about some of the positive aspects and why I think it may be something you want to consider.
Some famous, ultra-successful investors, like Ray Dalio, subscribe to the idea that gold and other volatile investments, like commodities for example, have a place in everyone’s long-term, all weather investment approach. Usually these more speculative positions only warrant a very small percentage of the overall total and that’s because the risk levels can skew the overall portfolios risk level in a way that hinders it from having an optimal blend of risk and return.
Other famous, ultra-successful investors, like Warren Buffett, stay away from investments like gold because of their lack of predictability in future price and because they don’t generate the income streams I mentioned earlier. It’s hard to recognize value in scenarios like that, but there are other ways to see if gold is a good value and that’s something I’ve been looking at lately for our private clients.
On a macro level, there are numerous reasons why gold has the potential to see its price go up in the foreseeable future. There’s a massive shift from west to east as countries like China, India, and several countries in Europe are acquiring large amounts of gold. And, in most cases, the governments of these countries are adding it to their treasuries rather than keeping it in circulation. The US dollar is still the world’s most dependable reserve currency, which is why President Trump can create pressure on China through trade in tariffs. If China could reduce its dependency on the US dollar by stabilizing their own currency and possibly even by using gold as currency to trade with other nations, that would remove a major economic tool from America’s toolbox and give China a competitive financial advantage it doesn’t currently have.
To see these types of trends play out fully, a person would likely need several years or longer to allow these large-scale developments to come together. Of course, a lot of things can interrupt the progress of those trends and leave the price of gold waiting in the wings for more information. That’s a concern, but overall, the trend is your friend when it comes to a level of demand for gold that surpasses its current supply.
Looking for value What I’m more interested in, and I think what you might be more interested in as well, is the apparent deep discount in value gold has relative to other investments, especially those in the US financial markets. Historically, the price of the Dow Jones average in the price of gold have normally operated in a ratio of around 8:1 to 6:1. Today, with the Dow Jones average just under 25,000 and the price of gold at roughly $1,300 per ounce, that ratio between the price of the Dow and gold sits at about 19:1. Let me put that in perspective and explain why that could be a very attractive opportunity.
In order to make these ratios come back to where they have been during the majority of the time over the past 100 years, one of three things would have to happen. The first scenario would be that the stock market stays put at its current levels and gold rises from around $1,300 to somewhere between $3,200 and $3,500 an ounce. That’s almost 3 times higher than where it is today, and while I’d like to think that’s possible, expecting that much movement in the price of gold is probably unrealistic.
The second scenario is that gold would stay put at its current price and that historic ratio between the price of the Dow Jones and gold would be realized again by the Dow Jones falling over 60%. That would take us from almost 25,000 down to 10,000 on the Dow Jones average or even lower.
While that kind of movement is possible, I don’t know if we’ll see that much movement in the next bear market or not. The last two bear markets we had were when the tech bubble burst in 2000 and when the world seem like it would come to an end financially during the global financial crisis of 2008. Both of those events caused the Dow Jones average to lose half of its value and even more in a period of less than a year and a half each time. After the big run-up we’ve had over the last 10+ years, and given how much debt the country has combined with how the Fed is reducing money supply and increasing interest rates, another drop like that could be possible in the next year or two. I’ll come back to why that could be significant for gold in just a minute. But let me address the third scenario, which is the more likely outcome.
I think I would be more surprised if gold tripled in value compared to the stock market losing 50 to 60% of its value, but I don’t believe either one will happen independent of each other. The more likely scenario is that the stock market will drop some and the price of gold will increase some. And it’s this reason that makes me think that gold is worth special consideration and well-balanced portfolio right now.
Understanding market mechanics The price of gold has been down for a while and because of its lackluster performance history, especially in light of how well the US stock market has been doing over the past decade, gold is not offered much appeal for the average US investor. Now when it comes to investing, people say they want to buy low and sell high, but what they do is usually the exact opposite. In order to buy low, you have to be willing to go into areas that are hated by the masses and place your hard earned savings into these deeply discounted areas trusting that their current values are below what their future values will be. Gold definitely has plenty deep value characteristics right now, which makes it a potential benefactor to receive money if the forecast for the stock market calls for pain.
When you observe the long-term behavior of the global financial landscape, you see that money never really leaves the game. It simply rotates from one area to another. And, if you can get ahead of where that money is going, you can make a lot in a short period of time. That’s the speculative part and that’s where people often get hurt by guessing incorrectly.
When the stock market declines, you sometimes hear the term “flight to safety” being used. Over the past 30 to 40 years, that flight to safety has included money rotating into bonds. But now, with rates rising, the prices of bonds are going down. And their interest rates were so low to begin with that it doesn’t take much of a drop when the principal value starts going down to put the return on those bonds in the red.
So bonds are not a logical place to find safety right now. International stocks are not a safe haven. Neither is real estate. Cash is safe and the yields on cash have been increasing some with rates rising, but going to cash with the majority of your investment portfolio is not usually a smart move for most people. When you’re an investment manager, like someone who manages billions of dollars in a mutual fund for example, you may not be able to hold cash, or certainly not very much. Many of those funds require the fund manager to be fully invested at all times. So what do you do in a situation like we’re in today?
Well, I suspect we will see some of that institutional money rotate into gold to take advantage of the deeply discounted value its price likely represents right now. The more sophisticated money like this usually is the first to rotate and their movement places further downside pressure on the area that they are selling, which then negatively affects the smaller, retail investor. They see the smart money moving away and then they try to follow it, which is what I think will eventually happen again this time. I just don’t know for sure that gold will be their safe haven of choice, but we have seen the price of gold creep about 5% higher in the last couple of months since we’ve started taking a position in it. The stock market dropped and then came back up during that period of time, but I find it interesting that gold did not give back its gains when stocks recovered from their lows in December. It could be that the early stages of this financial rotation are just beginning, and if they are, that could bring my third scenario where stocks decline while the price of gold increases into being sooner rather than later.
Don’t get greedy Before you get too excited and go load up on gold, let me remind you that you have to maintain a well-balanced portfolio of high quality investment to help ensure you get the best results possible. Speculating on where one investment or one investment class will go is a fool’s game and usually one that has a high cost involved with it. What I’m talking about here is exploring one potentially overlooked area of the financial markets and adding a small portion of it to your investment portfolio.
For our private clients, we have been building positions in an exchange traded fund that’s backed by physical gold held in a vault and audited on a regular basis. Having physical gold backing this investment helps ensure we never a liquidity issue if something unexpected happens and we want to sell everything we have in it. Other funds that leverage their position based on a smaller portion of gold they physically hold, can have higher price volatility, but more importantly, they can also have liquidity issues because they don’t have a unit for unit conversion rate in physical like the one we’re using does.
At most, I can’t envision us holding more than 10 or 12% in this gold investment for our private clients. I expect most of them will have even less, but you can examine the merits of what I’ve discussed with you here today and make whatever decisions you feel are in your best interest.
As I’ve said before, investments in the markets in general will either go up, down, or stay the same. If you have investments that produce income, they can help you during those up periods, provide a valuable stream of income when things are flat, and help offset downturns with that income, as well. With gold, the only thing you can hope for is that the price goes up. That’s a bigger bet to make, but it seems to have several things going for it on multiple levels right now.
Do your own research and see if gold has a place in your portfolio. It could help you create a more market neutral position with your savings, and that could save you a lot of money if and when we see a bear market in stocks again. Remember, market declines are not surprising events – they’re reoccurring events. At least now though, you have one more way to help protect yourself.