Investors have historically looked at gold as a safe-haven investment, a shelter from the volatility of financial markets during periods of economic uncertainty or outright crisis. Gold has long been a trusted store of purchasing power with its own intrinsic value, which appeals to individuals, institutions, and nations alike.
Over the years, gold has become the go-to asset for protection against financial market downturns. Recently, gold has come under fire, with some challenging its viability as a safe haven investment. However, a new study demonstrates that gold and other precious metals are still safe-haven investments during crises, particularly over the medium and long-term time horizons.
But how does gold actually manage to provide safety and security to investors during times of market distress? And how can you implement these diversification strategies to help you weather turbulent markets?
What is diversification?
Financial experts often talk about the importance of portfolio diversification. Diversification is an investment strategy used to manage risks by choosing to invest in a variety of different assets. The thinking behind diversification is similar to the old proverb “don’t put all your eggs in one basket,” meaning you shouldn’t rely too heavily on any one asset. It’s such a crucial concept that Nobel Prize-winning economist Harry Markowitz once said,
Diversification is the only free lunch in investing.
For example, if you had invested 100% of your portfolio in the Dow Jones Industrial Average index in 1987, your investment could have dropped 22% in a single day. With diversification, a more balanced portfolio comprising 60% stocks and 40% low-risk government bonds could have reduced the severity of an investor’s losses in the 1987 crash, according to many economic experts.
In an effort to maximize investment returns and manage risks, many investors turn to the method known as Modern Portfolio Theory (MPT). MPT was first introduced in 1952 by Markowitz, who asserted that each investment should be viewed by how it affects the risk and return of the investor’s portfolio as a whole. The goal of the MPT method is to strike a balance between potential returns and risk aversion.
The general approach of MPT is to buy and hold assets, occasionally rebalancing the allocation of the portfolio’s assets. Rebalancing is an important component of MPT because it helps investors avoid owning a disproportionate quantity of any one asset and allows investors to respond to price fluctuations in the markets. Disciplined rebalancing leads investors to sell high and buy low, which is challenging for most people, An example of rebalancing might include moving a percentage of the portfolio’s equities into cash or stocks into bonds. By doing so, the investor would move from a higher-risk asset to one that’s considered extremely low risk.
MPT investing often focuses on owning assets that have an inverse correlation, like oil futures and airline stocks, or gold and the stock market.
When the markets are in flux, gold – as well as silver, platinum, and palladium – can offer refuge against stock market losses and inflation. In other words, when markets go down, precious metals tend to go up (or, in some cases, go down less).
Diversifying your savings with precious metals can help balance stock market risk in your savings, particularly if you’re heavily invested in equities.
How does diversification work?
Diversification works by owning two assets that are inversely correlated, meaning when the price of one asset moves up, the price of the other is likely to move in the opposite direction. Let’s revisit our earlier example of oil and airline stocks. When the price of oil increases, the price of airline stocks usually declines. Why? Because airlines rely on oil to fuel their planes, and more expensive oil cuts into the profits of airlines, negatively impacting their earnings, profits, and, by extension, their stock prices.
By comparison, when the price of oil goes up, stock in energy companies tend to go up, as well. Why? Because the world’s largest energy companies produce oil, so a higher oil price means their profits rise.
Stocks and gold tend to have a relationship that resembles the one between oil and airline stocks. Generally speaking, the stock market’s performance is closely tied to the performance of the overall economy. When the economy is booming, stocks tend to perform well. When the economy is sluggish, inflation is high, and stock growth is slow, investors flock to gold and other precious metals, seeking an investment that’s safe and performs independently of the economy. (And when risky assets are in crisis, gold frequently enjoys a massive inflow of “safe haven” investment dollars.)
Diversification doesn’t just apply to the asset type, but also the geographic implications of certain investments. If 100% of your investment is in U.S.-based assets, you could be exposing yourself to an unnecessarily high level of risk and potentially catastrophic losses. To help offset that risk, you might invest a portion of your savings in emerging markets (more on this later). Fortunately, commodities including gold and other precious metals are global and don’t rely on any particular nation’s economy.
You don’t need to look far to see how this can apply to any investor in a real-life scenario. During the early part of the COVID-19 pandemic, many of the world’s stock markets were hard hit. For those who owned gold and other precious metals, these assets helped with diversification by lowering their downside. In fact, a study showed that even during this highly volatile time, precious metals successfully helped to balance investors’ portfolios, offering them a safe haven from the immediate market crisis as a medium to long-term investment.
In December 2021, two university professors – Huthaifa Alqaralleh and Alessandra Canepa – published a study titled “The role of precious metals in portfolio diversification during the Covid19 pandemic: A wavelet-based quantile approach.” In this study, Alqaralleh and Canepa used a unique statistical method to examine the relationship between major stock markets in BRIC (Brazil, Russia, India, and China) countries and the United States.
The study examined the early period of COVID-19 in 2020, analyzing the correlation between precious metals and stock markets when the pandemic broke out. In addition, the analysis didn’t just look at gold but also included silver, platinum, and palladium (the other three major precious metals).
The results of the study show that investors can use precious metals to effectively balance portfolios, even during times of extreme distress in the markets. The study also points to the specific metals and time horizons that are optimal for each situation. For example, gold and silver are both useful as safe-haven investments in the medium-to-long term, but they aren’t the only commodities investors can turn to when the markets are erratic.
Arlqaralleh and Canepa’s paper revealed that platinum and palladium can actually be a better option in some cases than the more frequently favored investments in gold and silver. Ultimately, the conclusion of the study is that a combination of gold and other precious metals have low correlation levels with equity markets, demonstrating their ability to help investors endure market volatility and economic distress.
The benefits of diversification from gold and other assets isn’t just limited to portfolio balancing. Diversification with precious metals can help hedge against many different types of risk, limiting downside and reducing volatility exposure. Owning gold and other precious metals can defend investors from currency risks, economic stress, and inflation, to name a few.
How do you diversify your portfolio?
You can diversify your portfolio by owning a variety of different assets that thrive in different economic situations. When you look at your portfolio, the allocation of monies to different assets should be balanced in order to maximize returns while managing an acceptable level of risk. Every person has a different risk tolerance, which will help determine the allocation of the investments in your portfolio. Other factors, such as age and time horizon, can play a role in investment allocation. The best way to determine your level of risk tolerance is to sit down with a professional to discuss your needs. At Birch Gold, we have experts on staff to help you through the options your have, so give us a call when you’re ready to talk about your financial future.
Financial advisors favor different methods and strategies for calculating the optimal portfolio balance and for rebalancing investments when needed. Most money managers and financial advisors will reallocate a portfolio as an individual nears retirement, moving away from riskier assets like equities. Rebalancing or reallocation may also be appropriate to consider on an annual basis, or when assets are sold, and the portfolio allocation deviates from the target figures.
Some experts, including the famed billionaire investor Ray Dalio, believe most people’s investment portfolios should contain 5-10% gold. Other estimates recommend precious metals make up an even more significant percentage of an investor’s portfolio, with as much as 15% of assets comprising gold and other precious metals.
Portfolio diversification can happen on a broader level, by mixing varying assets, or on a more granular level, within specific asset classes themselves. That means you can diversify your equities, bonds, and precious metals. While gold is the most popular precious metal for investing, many investors will diversify their precious metals investment by also buying some silver, platinum, and palladium. Instead of 10% gold, a portfolio might contain 5% gold, 3% silver, 1% platinum, and 1% palladium.
Precious Metals IRAs
True portfolio diversification can be a challenge for many investors, particularly when it comes to investing in retirement. Some account types – like 401(k) plans – can limit your investment options.
With a self-directed gold IRA, you can invest in a wider variety of assets – including gold and other precious metals – to achieve a more diversified portfolio. In addition, you can exercise more control over your investments, exchanging assets within your IRA without creating a taxable transaction.
When you’re ready to learn more about the benefits of a self-directed precious metals IRA, visit Birch Gold and take the next step to protecting, diversifying, and securing your future.