Michael Batnick recently wrote an interesting post about how financial advisors think when it comes to investing in gold. In the article, he suggested that most investors, including financial advisors, fall into one of two camps. Either they own almost no gold (3%), or they own a 50%+ gold allocation. He went on to share his own view on gold, which was the following:
“I see nothing wrong with a permanent 10% position in gold, for example, but the problem is, I’ve never heard of anyone actually keeping 10% of their portfolio in gold. It’s either 50% or 3%, which does nothing.” — Michael Batnick
This statement struck me when I read it. The reason is, for many of my clients, I actually do keep a 10%+ permanent position in gold. When gold goes up in price relative to other investments, I trim the gold position to rebalance. Similarly, when gold goes down in price relative to other investments, I add to their gold position to rebalance.
Michael didn’t explain why he thought a 10% permanent position in gold makes sense, so I thought I would share a few of my reasons why many of my clients own a 10%+ permanent position in gold.
Bad Reasons to Invest in Gold
Let’s begin with a list of weak reasons to own gold (in my opinion). If you are going to own an investment, whatever it is, your reasoning should be defensible. If your logic for investing in the first place isn’t sound, then you may end up selling for a wrong reason too.
- You shouldn’t buy gold because you don’t like Donald Trump, and you also shouldn’t buy gold because you do like Donald Trump. I would not make any asset allocation decisions based on politics, with gold or with any other asset class.
- You shouldn’t buy gold because you expect the dollar to collapse. The dollar is the global reserve currency and will continue to be widely used, even as its value gradually depreciates over time. The likelihood of the dollar collapsing in price one day like the Venezuelan Bolivar is extremely remote.
- You shouldn’t buy gold because you don’t trust financial markets. Like them or not, markets have been around for hundreds of years, and they aren’t going anywhere. The same holds true for central banks.
Gold is worth owning, in my view, but not for the reasons listed above. You should have sound, defensible reasons to own a permanent position in gold.
Good Reason #1: Opportunity Cost of Owning Stocks and Bonds
The opportunity cost of a holding a long-term 10% position in gold is currently low. U.S. stocks are expensive, while bond yields are near a 5,000 year low. Traditional investments such as U.S. stocks and investment-grade corporate bonds currently do not pay investors appropriately for the risk involved. During the past thirty years, the typical 60/40 (stocks/bonds) investment portfolio has performed remarkably well for investors. However, that same 60/40 portfolio is not likely to work as well going forward. With U.S. stocks and corporate bonds expected to generate anemic returns during the coming decade, why not allocate some of your capital elsewhere?
Good Reason #2: Financial Repression and Negative Interest Rates
Financial repression is a term used by economists to describe a set of monetary policies whereby interest rates are kept below the rate of inflation for a multi-year period. When interest rates are lower than the rate of inflation, that means that real interest rates are negative. Investors tend to buy gold when real interest rates are negative because they expect gold to hold its inflation-adjusted value over time better than bonds. Currently, we are in a period of financial repression that could last as long as a decade or more, which suggests to me that an increasing number of investors are going to build an investment allocation to gold to keep up with inflation, and that should lead to higher gold prices.
Good Reason #3: Low Correlation to Other Asset Classes
Gold prices have demonstrated a low historical correlation to both bond prices and stock prices. Gold often goes up in price during periods when stocks or bonds go down in price. Similarly, gold could go down in price when stocks or bonds go up in price. Constructing an investment portfolio where you own a bunch of uncorrelated asset classes and rebalance regularly works better with gold as a part of the mix.
For example, owning a meaningful gold position would have provided downside protection during the bear markets shown in the chart below; during most of the bear markets of the Post World War II era, gold prices appreciated considerably.
By owning uncorrelated assets, including gold, you reduce volatility in your investment portfolio and, in doing so, you should be able to improve your long-term risk-adjusted returns.
Good Reason #4: Contrarian, Undervalued Investment
Most Western investors don’t own gold. Hardly any institutional investors own gold. Gold remains an unpopular investment, which might be why Michael Batnick doesn’t own gold. Most investors would rather own traditional financial assets like U.S. stocks and U.S. corporate bonds because that’s what has been performing so well during the current bull market in both stocks and bonds.
However, astute investors know to look for investments which are unconventional, unpopular, unloved, and are priced accordingly. Remember Rule #2: The price you pay for a long-term investment will likely be the primary determinant of your risk and your reward.
The chart below shows the relative price of real assets like gold compared to financial assets like stocks and bonds. As the title suggests, real assets are at all-time lows relative to financial assets. Eventually, this will mean revert, and it’s worth positioning your investment portfolio accordingly.
Good Reason #5: Dollar Depreciation
In 1971, President Nixon closed the gold window (a.k.a. “End of Bretton Woods” in the chart above). Since then, the U.S. dollar has served as the global reserve currency. As a result, most international trade transactions since the 1970s have been conducted in U.S. dollars, including cross-border transactions in which the United States is not even a party.
Today, however, the international monetary system is in the midst of a significant regime change.
Foreign countries are beginning to transact in other currencies besides the U.S. dollar, such as the Chinese Yuan. As the dollar gradually loses market share to regional currencies such as the Yuan and the Euro, foreign central banks are going to diversify their foreign exchange reserve holdings by owning fewer U.S. Treasuries. Indeed, since 2014, central banks have been net sellers of U.S. Treasuries and net buyers of gold.
For many years, foreign central banks were an important source of demand for U.S. Treasuries and an important source of support for the dollar. Without that support, and with a continuing current account deficit, the dollar should depreciate versus other currencies over time, and, relatedly, the price of gold should rise.
How Much Gold Should You Own in Your Portfolio?
Without knowing your individual financial circumstances, I can’t provide a personalized recommendation to answer this question for you. However, in my opinion, a 10%+ position is appropriate for many investors, and especially so if the rest of your investment portfolio is somewhat domestic and dollar-centric.
In my view, owning a 0-3% position in gold is a mistake. By holding virtually no gold, you will probably have a larger allocation to more expensive U.S. stocks and low yielding U.S. bonds. Your portfolio will be less diversified because you won’t be taking advantage of gold’s low correlation to U.S. stocks and bonds. If financial repression continues for an extended period, you might find that the purchasing power of your investment portfolio declines over time.
At the same time, owning a 50%+ position in gold is also a poor idea, because you are putting too many eggs in one basket. To take advantage of the benefits of diversification (see reason #3 to own gold above), you should not own too much of any single asset class unless you are willing to risk steep losses should that asset class decline significantly in price.
You don’t want to own too little gold, and you don’t want to own too much gold. In my judgment, for many investors, a 10%+ position sounds about right.
What is your exposure to gold, and, more importantly, how did you come to that decision?
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