Enhance Returns and Reduce Risk by Diversifying Your Portfolio with Precious Metals

As the old Wall Street saying goes, “Put 10% in gold and hope it doesn’t work.” A recent study by Ibbotson Associates, commissioned by Bullion Management Services Inc., confirms that might not be such a bad idea. And, historically, that has worked just fine — even in the absence of economic calamity.

The Theory of Diversification

Te idea behind asset allocation is asset classes are diverse. Historically, stocks and bonds tended to appreciate and depreciate in opposite directions. Therefore, a portfolio was sufficiently diverse if it held both stocks and bonds, with maybe a little cash on the side. Gold, so long as the dollar was still tied to it via the gold standard, and other precious metals were rarely given much consideration, since most world currencies were backed by hard assets.

But once President Nixon “closed the gold window” in 1971, an interesting thing began to happen: Stocks and bonds started trading relatively in tandem. For example, from 1926 to 1969, the correlation between stocks and bonds was -0.02; meaning that if stocks as a whole went up by 10%, you could expect bonds to go down by 0.2%, and vice versa.

But since 1970, the correlation between stocks and bonds has ranged anywhere from -0.03 to +0.80. At the far end, this meant when stocks, as an asset class, went up by 10%, bonds went up by 8 % — and if stocks went down by 10%, bonds lost 8% of their value. What good is such “diversification?”

But what of gold and other precious metals? Using the SPMI (Spot Precious Metals Index), which consists of equal parts gold, silver, and platinum bullion, precious metals have had a -0.10 correlation with U.S. large-cap stocks in the years 1972 (the first year gold was detached from the U.S. dollar) through 2004, and a -0.18 correlation with long-term U.S. government bonds. Thus, precious metals proved to be a legitimate diversifying hedge.

Hedging Against Inflation

Another important finding from the study was the SPMI’s validity as a hedge against inflation. U.S. large-cap stocks (-0.22), U.S. small-cap stocks (-0.06), international equities (-0.19), long-term U.S. government bonds (-0.39), and intermediate-term U.S. government bonds (-0.22) all had negative correlations to inflation.

Only 90-day Treasury bills (+0.63) and the SPMI (+0.43) moved in the same direction as inflation. But of course, the rate of return on 90-day T-bills was not as high as gold, silver, and bullion over the thirty-two-year period, making the SPMI the superior investment.

In fact, the SPMI was the best hedge, not only against inflation, but against all other asset classes. U.S. large-cap stocks, for example, had an average correlation of +0.26 to the six other asset classes. U.S. small-cap stocks’ average correlation was +0.22. International equities (+0.15), long-term U.S. government bonds (+0.18), intermediate-term U.S. government bonds (+0.19), and even 90-day T-bills (+0.03) all had positive correlations, but not the SPMI — its average correlation was -0.06, proving to be the only asset class that legitimately diversified investors from 1972 to 2004.

Putting it All Together

Obviously, most financial planners would advise clients against putting all of their eggs into one basket — even if the basket were made of gold, silver, and platinum. Over the course of the thirty-two years examined in the Ibbotson study, the three equity classes (U.S. large-cap stocks, U.S. small-cap stocks, and international equities) outperformed all other asset classes.

However, it is important to note that during the high-inflation years of 1973 through 1984, the SPMI was the best-performing asset class, giving it the longest run of any of the asset classes.

Every investor knows that there is no one “best” asset class, and winning portfolios contain the best of many, if not all, asset classes. This hunch, which most investors have, was proven empirically by the Ibbotson study.

Ibbotson made three portfolios based on risk tolerance. The conservative portfolio consisted of 4.5% U.S. large-cap stocks, 10.3% U.S. small-cap stocks, 9.6% international equities, 2.4% long-term U.S. government bonds, 30% intermediate-term U.S. government bonds, and 43.2% 90-day Treasury bills.

Given this asset-class mix, the portfolio would have had a 6% annual rate of return from 1972 to 2004. But if 7.1% were invested in the SPMI, the expected return would be boosted to 6.2% while simultaneously minimizing risk (a Sharpe Ratio of 0.464 vs. 0.426 without precious metals — the higher the Sharpe Ratio, the better the risk-adjusted rate of return).

Even more striking were the results of the moderate model portfolios. The moderate model portfolio without precious metals (15.5% large cap, 17.6% small cap, 21.5% international, 8.3% long-term bonds, 25.4% intermediate-term bonds, and 11.8% 90-day bills) had an 8.6% expected return and a 0.437 Sharpe ratio. But by allocating 12.5% of assets into the SPMI, the expected return was increased to 9% and the Sharpe Ratio was boosted to 0.472.

Finally, there was an aggressive model portfolio, which performed best of all. It allocated 19.2% into large-cap stocks, 32.5% into small-cap, 31.6% into international stocks, 7.9% into long-term bonds, 5.3% into intermediate-term bonds, and 3.6% into 90-day T-bills. Without precious metals, this portfolio had an expected return of 11.1% and a Sharpe Ratio of 0.428. But with a 15.7% SPMI allocation, the expected return was boosted to 11.6% and the Sharpe Ratio to 0.453.

The Future of Precious-Metal Investing

Since at least the 1970s, “goldbugs” have been predicting an imminent economic collapse in the U.S. (if not the world) and citing this as the reason everyone should buy gold (or silver or platinum). While there are numerous signs pointing to a potential “Financial Armageddon” in the decades ahead, Ibbotson’s study proved that, even in the absence of a global economic implosion, precious metals help diversify, hedge, and improve the performance of your portfolio while limiting risk.

Every investor might think about putting between 7.1% and 15.7% of his or her portfolio into hard assets, but there’s no need to “hope it doesn’t work” — it will work. The only question is, how well?

Tags: silver investing, silver-portfolio

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2 Comments to Enhance Returns and Reduce Risk by Diversifying Your Portfolio with Precious Metals

1. 

   Sorry I didn’t get to read this full article, but just stopping by to show you a new site I’m working on WhySilver.org

   Take care, and definitely send feedback.
Josh on August 11th, 2007

2. [...] or the future of society, more than 10% of your entire investment portfolio is too much. An ideal portfolio allocation is around 7%-11%. If you are just beginning in silver: start small. Here’s another tip for beginners, it’s a [...]
» The Seven (Potentially) Deadly Sins of Silver Investors on September 17th, 2007