Guest Post by Jim Rickards from his blog The Daily Reckoning:
Gold was down again today, but overall it’s had a good run lately (for a change).
Gold rallied from $1,624 per ounce on Sept. 28 to $1,701 at the close on Oct. 3 for a 4.74% gain after two months of steady losses.
It’s too soon to applaud or even put the Champagne on ice. Gold is down almost 20% from its March high and is having one of its worst years since 2013. Maybe this is a turning point, maybe not.
On the flip side, nor is it time to panic. Prices could really take off from here. We’ll see.
But today, I’d like to turn away from price swings and look at another important aspect of gold investing — quantity.
Specifically, I’ll discuss the right quantity of gold allocation for your portfolio expressed as a percentage of investable assets.
As an investor, that’s very important.
Is Your Portfolio Truly Diversified?
The term “investable asset” is narrowly defined. It does not include your home equity or business equity.
You should not take market risk with the roof over your head or the way you earn your livelihood. Whatever liquid net worth you have after excluding your home and business comprises your investable assets.
From there, portfolio allocation is a matter of achieving diversification that leaves your portfolio robust to all states of the world. “Diversification” is another term that is not well understood.
I run into investors all the time who have 90% of their investable assets in equities (especially passive index funds or sector ETFs) and claim to be diversified.
They’ll point out that index funds and ETFs can be composed of 50–500 stocks in 10 or more major sectors such as technology, mining, retail, consumer durables, etc. They’re highly diversified!
I tell them they’re not diversified. They may have 50 or 500 stocks in 10 sectors, but they are in one asset class — equities.
When you don’t need diversification, the equities may display idiosyncratic performance that blends to an average performance. When you most need diversification, the idiosyncratic behavior disappears overnight and all stocks (regardless of the sector) will sink like a stone in lockstep.
I call this strategy faux diversification — it’s not there when you need it.
Real Diversification
Real diversification reaches across asset classes to include equities, notes, real estate, private equity, cash, natural resource commodities and… gold. In every state of the world, some of those asset classes will perform poorly, but others will outperform.
Cash reduces overall portfolio volatility (it’s the opposite of leverage) and offers optionality when it comes to reweighting a portfolio or shopping for bargains in the wreckage of a meltdown.
Curiously, cash can be your best-performing asset in deflation when the real value of each dollar goes up. Don’t rule that out. Coming up with a diverse list of asset classes then raises the issue of weights.
What percentage of your total portfolio should be allocated to each asset class?
When it comes to gold, I have long recommended a 10% allocation. This surprises many people.
People say, in effect, “If you’re so bullish on gold, why not a 100% allocation or at least 50%?”
There are many answers to this question (and the implied critique).
The first is that I could be wrong. Gold could drop to $500 per ounce. I don’t expect that, but it’s foolish to rule it out.
The Importance of Humility
At a 10% allocation, gold could go to $500 and your portfolio would still live to fight another day. A bit of humility goes a long way when it comes to investing your life’s savings.
The second reason is that gold price action is asymmetric in my view. The price can go up or down, but the upside potential is much greater than the downside risk. If that’s correct, a 10% allocation will serve you well in the high-return scenario, but you won’t be hurt too badly in the low-return scenario.
For example, let’s say you have a 10% portfolio allocation to gold and the price goes up 200% from $1,665 per ounce to $5,000 per ounce. A 200% gain on a 10% allocation adds 20% to your portfolio.
Conversely, if gold drops 20% to $1,330 per ounce, your portfolio loss is only 2%.
If gold does have more upside than downside, then a 10% allocation will produce large gains but protect you against large losses.
The third reason is that nothing happens in isolation. Could gold drop to $1,000 per ounce? That’s not my forecast, but the answer is yes.
Still, think about what else is happening in the world of $1,000 gold. That’s a world of deflation and likely economic collapse. It means stocks could be down 60% or more from current levels.
That means 11,800 on the Dow Jones Industrial Average index.
Gold Is a Store of Value
In that world, I’d rather have my $1,000 gold than a stock portfolio trading at Dow 11,800.
Everything is down but gold has outperformed. That’s part of gold’s job as a store of value.
Finally, overconcentration in one asset class is never a good idea regardless of the asset.
If you were all-in on dot-com stocks in 2000 or subprime mortgages in 2007, you know what I mean. Besides even if gold is performing well with your 10% allocation, that doesn’t mean other assets aren’t performing well also. The world of rapidly rising gold prices is probably a world where real estate, fine art and commodities are doing well too.
A 10% allocation to gold in a rising gold market does not imply high opportunity costs. You could do quite well on some of your other asset classes. That’s the power of diversification.
If you have a 10% allocation to gold right now, sit tight. If not, this is a great time to top up your allocation. That’s the one good thing about lower prices.
It’s a great entry point for those not yet fully allocated.
Guest Post by Jim Rickards from his blog The Daily Reckoning.
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