5 Reasons Gold is a Diversification Tool

Prudent investors understand the necessity of owning precious metals such as gold. We agree that in the short term gold has entered a cyclical bear market, but the long term reasons for owning gold are intact. In fact, given the delayed nature of money printing policies and inflation, one could make the case that the long-term outlook is more bullish than ever!

Of course, as Aristotle advised, “Moderation in all things.” For Dark Horse Wealth, owning a modest amount of precious metals is a prudent decision. The question is not IF you should own precious metals, but rather what is the optimal amount you should own given your risk tolerance? The recent sell off in precious metals should not spook investors provided they understand the reason to own gold in the first place!

Reason #1: Diversification. It’s Mathematical!
Independent studies validate the point that you cannot be properly diversified without owning gold. This has been proven in asset allocation studies from experts at Oxford Economics, Ibbotston Associates, and many others who have written quantitative reports explaining these points. Caveat Emptor: these studies are based on historical data which means there is no guarantee that such relationships will hold in the future. Further, this reasoning should pass the investor “sniff test” because precious metals are the only hard money alternative to paper money! Hence, precious metals, specifically gold, have strong diversification properties.

Reason #2: Insurance Properties. Hedging the Unforeseen
Gold has insurance qualities that have historically made it a safe-haven in uncertain times. This means gold can outperform when the rest of your portfolio under-performs or vice-versa. J.P. Morgan recently summarized gold’s insurancelike qualities in a July 2012 global asset allocation study concluding, “Gold also helps to hedge against high inflation, a dramatic fall in one’s currency, and extreme corrections in equities.”



Recalling the 1970 to 1981 bull market in gold.
Inflation (CPI-U) is the blue line and the gold price is the red line. Was Gold a BUBBLE in 1975? Considering eliminating precious metals from portfolio’s MAY be reasonable if interest rates rise 2% ABOVE inflation or if we see double digit interest rates on bonds. With inflation ABOVE 2% and 10 year interest rates BELOW 2% we are long ways from that scenario.


Reason #3: Not a Bubble. Low Investor Allocations
The last time gold made an inflation-adjusted high, the average investor’s allocation to gold in the US rose to 26% at the peak in 1981. Currently, average investors are holding low, not high, percentages. As a percentage of global financial assets (stocks, bonds, loans, cash etc), gold has fallen from 5% in 1968 to 0.7% as of 2010. Institutional investors (pensions, insurance, etc) in the US only hold an average of 0.3% of their assets invested in gold. So despite the rise in the price and popularity of gold and silver, very few have allocated capital to them in any significant way.

Reason #4: Central Banks Are A New Source of Demand
Similarly, emerging market countries appear to be under-allocated in gold and over-allocated in US dollars. Watch what they do, not what they say! Central banks were a source of gold supply to the markets up until 2009. Starting in 2010 they became net buyers. According the World Gold Council, in 2012 gold demand from Central Banks was the highest it has been in 50 years.  Further, the majority of emerging market countries have less than 10% of their currency reserves in gold. For example China only has 1.9% of their reserves in gold and over 50% in US dollars. On the other hand, the US, Germany, France and Italy all have over 70% of currency reserves in gold. Clearly, emerging economies have a lot of gold purchasing to do in order to catch up or they can just continue owning US Dollars at near 0% interest rates.

#5 Perceptions of Money and Value
The concept of “money” is underpinned by a widespread believe (faith) that it will hold its long term value. Consequently, it is used as medium of exchange for goods and services, and as a vehicle for lending, saving, and investment. For 4000 years, precious metals have been viewed as a store of value. Paper currency systems, set up primarily by governments, and not backed by gold, have attained widespread acceptance as money starting a mere 40 years ago when President Nixon officially broke the gold standard in 1971.

We concede that we could be wrong in our trust in gold as a long term store of value but take a step back and think about it from this viewpoint: A modest allocation to precious metals means hedging forty years’ worth of accepted (belief) in paper money with 4000 years’ worth of historical trust in precious metals as a store of value. It seems like a clear-cut, prudent investment decision in our opinion, which is well worth the modest downside risks.

This recent sell-off of gold (and possibly silver) should be an opportunity for investors who don’t have a gold allocation or aren’t sure of how much gold exposure they have in their portfolio. If that is the case, they should revisit the issue with their investment professional. Hopefully he or she has some knowledge of why gold is an important asset allocation tool, but if not, you are now armed with the basic facts regarding the usefulness of a gold allocation.

REMEMBER: The key problem for investors as it relates to precious metals is not IF they should own them, but rather how much of them they should own.

Dark Horse Wealth helps it’s clients by converting complex concepts into usable information so together we build a clear and successful investment strategy that addresses their specific needs.