Three reasons to own gold as part of a diversified portfolio

With the exception of perhaps Bitcoin, there are few investments as polarising as gold. Warren Buffet has avoided it since it has no utility value.

Ray Dalio of $175 billion Bridgewater Associates preaches the opposite.

“If you don’t own gold… there is no sensible reason other than you don’t know history or you don’t know the economics of it.” – Ray Dalio

Views on gold as an investment are generally more a matter of philosophy rather than fact. Gold is a difficult asset to value and market commentators love to speculate what is causing the daily moves.

As a result of the fixation by many people on short-term gyrations, little discussion seems to go into the value of owning gold as part of a long-term portfolio.

Unlike shares and bonds which generate dividends, gold doesn’t generate regular cash-flows so investors in gold can only benefit from capital returns.

Unlike other commodities like iron ore or oil, there’s little industrial use for gold. It doesn’t power our smartphones or enable the production of steel for buildings. Gold can’t be depleted or destroyed either.

The majority of the demand for gold in the world comes from either jewellery or investment. So when investors buy gold they are investing in an asset whose major use is simply as ‘an investment’ – and not much else.

I’ve advised Stockspot clients to have an allocation to gold via the GOLD exchange traded fund (ETF) since 2014. The GOLD ETF is physically backed by gold bullion which is stored in a vault in London. It’s unhedged so investors benefit from a falling Australian dollar.

In late 2017 I increased the GOLD ETF allocation from 10% to 12.3% for all client portfolios because I identified the need for more exposure. The negative correlation between shares and bonds had weakened which meant that bonds may not provide as much of a cushion in a share market correction scenario.

The yellow metal has since performed better than most asset classes including Australian and global shares, notching up a return of 23%. Over the past year gold has outperformed shares too.

There are three reasons I continue to advise clients to maintain an allocation to gold in their portfolios:

1. As a diversifier

Harry Markowitz won the 1990 Nobel Prize in Economics by showing how to achieve the best return potential by combining assets with a negative relationship to each other (correlation).

His seminal work, Modern Portfolio Theory (MPT), continues to be the best regarded theory for managing portfolios, and is how I approach building portfolios.

Gold has a very low or negative correlation with most other investment assets which is why it typically moves in a different direction to shares. This is a rare quality for an asset and it means that gold has the ability to reduce the risk of a portfolio.

In finance-speak, gold helps to improve the quality of the portfolio returns which means you can earn a similar return with less risk.

2. As an insurance policy

Gold has historically been an effective way to preserve the real value of your wealth since it acts as an insurance policy against currency devaluation.

This is when your home country currency loses its global purchasing power either because of economic factors or monetary policy. While gold in US dollars is well below where it traded in 2012, in Australian dollars it trades at an all-time high due to our weak currency.

3. As a safe haven

Government bonds have historically been one of the safest places to park your money. Today however there is a record US$14 trillion of government debt issued by creditworthy governments that trades on negative yields. In countries like Japan, Switzerland and Germany you need to pay the government to borrow your money.

While gold doesn’t have a yield, it’s still a more positive yielding asset than negative yielding government bonds which penalise owners. As the amount of negative yielding government debt increases, so too does the attractiveness of gold.

Why now is the time to own some gold

I continue to see gold as an important portfolio diversifier regardless of your investment horizon or risk capacity. It’s even more important for growth focused investors right now since shares and bonds are dancing to the same tune.

Gold has historically been able to maintain its purchasing power and provide portfolio insurance in times of need. It will continue to benefit from the swelling pool of negative yielding government debt.

Like insurance, it’s the part of your portfolio you’ll be glad you have when the rest of the investment world isn’t shining.

Article originally published in The Australian and Stockspot blog