At this time of strength in the stock market and weakness in the price of gold, investment managers might be questioning what role, if any, gold can play in a portfolio.
We all witnessed the Dow Jones industrial average's climb above 8,000 in July, just two months after it topped 7,000. According to most methods of stock valuation, the market is at a high level. For instance, price-earnings ratios are high and dividend yields are low by historical standards.
In contrast to today's high level of equity prices, the gold price is perceived as being at a relatively low level. Therefore, the upside potential for gold appears to be greater than the downside. So the question is: When will the stock market next revert to the mean (that is, move downward) and when will gold move up?
The mere threat of a market correction is alerting portfolio managers to shift their focus toward a strategy aimed at preservation of wealth in order to protect their huge investment gains of recent years. One such preservation strategy is to include gold as a component of a portfolio. Indeed, this is the first time since 1975 (the year when U.S. investors were legally permitted to hold gold) that financial market conditions have become so compelling that investors may wish to consider gold as a long-term portfolio investment.
an efficient diversifier
Whether one's investment style is conservative or aggressive, gold can play an important role in a portfolio's performance. A typical portfolio is invested in a combination of financial assets such as stocks, bonds and money market instruments. Adding gold to this type of portfolio sometimes introduces an entirely different type of asset class -- a tangible or "real" asset -- thus increasing the portfolio's degree of diversification.
The purpose of diversification is to protect the total portfolio against fluctuations in its value. Gold provides this kind of protection. "Including gold in an existing portfolio can improve investment performance by either increasing returns without increasing risk, or by reducing risk without adversely affecting returns," wrote Raymond E. Lombra, professor of economics at Pennsylvania State University, in a February 1995 study entitled, "An Economic Analysis of Allowing Legal Tender Coinage and Precious Metals as Qualified Investments in Individually Directed Retirement Accounts."
The reason is basic: The economic forces that determine the price of gold are different from, and in many cases opposite to, the forces that determine the prices of financial assets. For example, when equities go up, gold tends to go down -- and vice versa. Gold is the only asset class that is negatively correlated to virtually all other asset classes. For example, whenever the gold price increases, there is a 30% probability U.S. stocks will decline. Thus, the inclusion of gold usually reduces the volatility of a portfolio to a greater extent than the inclusion of any other asset class.
A golden impact
A recent World Gold Council study compared the performance of a series of portfolios with and without gold. Four different portfolios with varying degrees of volatility (containing domestic and foreign stocks, bonds, real estate and cash of varying weights) were rebalanced to include a 10% gold investment. The study used data from year-end 1976 to year-end 1996, provided by Ibbotson Associates, Chicago. In each case, the inclusion of gold was shown to either enhance portfolio return without increasing risk or reduce risk without sacrificing return.
Traditionally, portfolio managers have followed the balanced account or 70-30 strategy as a means of diversifying their assets -- that is, 70% of the portfolio's assets are made up of stocks and 30% bonds. However, this strategy of diversification is now being questioned. The prices of stocks and bonds no longer move in the opposite direction to such an extent as in recent decades.
In order to illustrate this change in the relationship between stocks and bonds, the World Gold Council examined the correlation between monthly returns in the stock market (as measured by the Standard & Poor's 500 stock index) and the U.S. bond market (the Lehman Brothers Aggregate index) over rolling five-year periods between 1987 and 1996. The main conclusions are:
Correlations between stocks and bonds have increased threefold since the end of 1987; and
Each year's correlations between stocks and bonds are positive.
Accordingly, portfolio managers now have to look to other asset classes to gain portfolio diversification. Ideally the asset class being sought should be negatively correlated to the stock market in order to provide the maximum portfolio risk reduction for the unit of asset added. It turns out gold is the most negatively correlated asset to the U.S. stock market. The relationship between these two asset classes is illustrated in the accompanying chart:
There is no trend in the correlations between gold and the stock market.
All correlations between the gold price and the stock market are negative.
This analysis demonstrates gold bullion is an excellent "scientific" portfolio diversifier vis-a-vis equities. This is a particularly important finding since stocks and bonds no longer are behaving as mutual diversifiers.
What sets gold apart from other alternative assets -- such as real estate, timberland, venture capital and commodities -- is its high degree of liquidity. For instance, the bid-offer spread for bullion transactions is as narrow as the trading spreads for liquid assets such as stocks and bonds.
Another indication of gold's liquidity is the ease with which it can be converted into cash. Trading in gold is carried on 24 hours a day in markets around the world. Also, major participants in the gold market include some of the world's highest-capitalized banking organizations.
Finally, the actual time it takes for a trade to be executed in gold is usually much shorter than for other alternative assets. It takes about the same amount of time to execute a trade in gold as in stocks and bonds. On the other hand, real estate, venture capital and timberland can take days, months and even years.
Current financial-market conditions indicate the case for including gold in a portfolio is better than in many a decade. The U.S. equity market is at an unusually high level, while the gold price is unusually low. Furthermore, portfolio managers are seeking alternative investments now that they are so heavily invested in conventional assets. In this setting, looking at gold makes a lot of sense.