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Precious Metals and Portfolio Diversification

Diversification is a term many have heard, but few understand. Without getting into any fancy definitions, diversification is a way to try and improve returns for your level of risk. What does that mean? Well, it means that one can construct a portfolio based on numerous factors such as one’s age, time horizon and volatility tolerance. In order to try and maintain one’s level of risk, a mixed portfolio of various asset classes may be used.

It should be clear that diversification is not intended to boost portfolio performance, and that it is no guarantee against losses. A well diversified portfolio may, however, potentially keep portfolio volatility to acceptable levels.

How Do Precious Metals Add Diversification?

Gold, silver and other precious metals are often used as diversification tools. Some may buy physical precious metals to accomplish this end while others may use paper assets such as gold or silver based ETFs.

It is important to keep in mind that many investors feel they are properly diversified when they are actually not. For example, many believe that if they own stocks and bonds they are diversified. Others believe that if they own a mix of mutual funds they are diversified. Some have stocks, bonds and cash and believe they are adequately diversified.

The reality is that there are several other asset classes that can be utilized for diversification purposes. Precious metals are one of them, along with real estate, collectables, and commodities. That being said, most investors are only using one to three of several asset classes available.

Let’s now discuss a few ways that physical gold, silver and other precious metals may help achieve portfolio diversification:

Low correlation to stocks: Precious metals generally have little correlation to equities. While at times precious metals may have an inverse correlation to stocks, on larger time frames this correlation does not hold. The precious metals markets may move with stocks or inversely, and many of the forces that drive the price of gold, for example, differ from and in many cases counter the forces that drive other asset classes.

Purchasing power: Gold and other precious metals often exhibit an inverse correlation to the U.S. dollar. As a dollar denominated asset, gold prices may rise when the dollar is falling and may fall when the dollar is rising. As the dollar falls, one’s purchasing power is reduced. Every dollar now buys less goods or services. In order to try and protect against a loss of purchasing power, physical gold or silver ownership may potentially be beneficial. If the dollar weakens, then the net returns of other investments actually weaken too-because those returns now buy less. Should gold, silver or other precious metals rise in light of a weaker dollar, those gains may potentially help offset the purchasing power being lost.

Geopolitical risks: Gold and other precious metals may potentially rise during periods of economic or geopolitical risk. Gold is often viewed as a “safe-haven” and as such may see buying interest when investors get nervous. If a war were to break out, for example, stocks and other risk assets may be sold off as investors look to try and protect capital. Gold, having little correlation to stocks, may potentially rise in price during these times.

The same can be said for any significant economic crises. If stocks are sold off, gold and other precious metals have the potential to move higher as investors seek their perceived safety. It is no secret that sovereign debt issues are a major problem in today’s world, and could cause a large scale financial meltdown. If this issue or any other large scale economic issue started to cause ripples in global financial markets, precious metals could potentially benefit as investors look for alternative asset classes to put capital to work in.

While this list could go on and on, we think it will give you the bigger picture.

Should I Buy Physical Metals or Paper Products?

We believe that owning physical, tangible precious metals is the way to go. Paper metals products such as ETFs and gold mining stocks carry significant counterparty risks. In addition, they will be of little to no help in case of a real global emergency.  Shares of an ETF, for example, will not buy food or a gallon of gas. Physical precious metals, on the other hand, carry zero counterparty risk and can be used for exchange anywhere in the world.

How Much of My Portfolio Should Consist of Precious Metals?

This is a difficult question to answer, and there is no ‘one size fits all.”  Some experts recommend a 10-12 percent allocation to precious metals while others recommend a much higher amount. How much you decide to allocate to precious metals will depend on many factors including age, risk tolerance, economic outlook and others. We recommend discussing the issue with your financial professional as well as examining your own thoughts on the economy, your existing portfolio make up, your volatility tolerance and your objectives.

This material is for informational purposes only. No investment advice is being given or implied. Please consult your financial professional for questions related to portfolio diversification and the use of precious metals.