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Can Precious Metals Save Your Portfolio?

With the recent market turmoil, investors of all types are increasingly turning to an asset class that has been out of favour for decades; precious metals. Gold in particular is attracting serious attention. In recent months we've seen Bill Gross of PIMCO, who manages the world's largest bond fund, liquidate most of his US treasury holdings in order to purchase the yellow metal. The University of Texas's pension fund, one of the world's largest pension funds, recently put 5% of its holdings in to gold. Last year, the Central Bank of India bought 400 tons of gold from the International Monetary Fund. The Mexican Central Bank bought 100 tons of it this year, and many other central banks are following suit. For decades, central banks had been net sellers of gold and as of last year they reversed course and are now accumulating gold with a vengeance.

Central banks the world over have been using US dollars as reserves, which prop up the value of their own currencies. This is a remnant of the Bretton-Woods system, where the US dollar was pegged to gold at $35/oz and then used as central bank reserves. This system created the impression that all the world's currencies were backed by gold through the US dollar. If the dollar was ever in peril, those central banks could redeem the dollars for gold. That all collapsed on August 15, 1971 when President Nixon terminated the gold redeemability of the dollar because a run on the currency was imminent. France was demanding the redemption of their US dollars in to gold and the world would soon follow suit as the cat was out of the bag and foreign governments were taking notice of the fact that the USA didn't have enough gold to cover its obligations. The system has limped on ever since and the rush back to gold is now underway.

The annual returns on gold and silver have been spectacular:

2005 2006 2007 2008 2009 2010
Gold 17.77% 23.92% 31.59% 3.41% 27.63% 27.74%
Silver 30.43% 46.09% 14.42% -26.90% 57.46% 80.28%

Precious metals have served as money and a store of value for thousands of years. Recent research has proved gold's usefulness and importance in the world economy. Investors should take heed because they stand to reap immense benefits. A report published October, 2010 by the highly respected World Gold Council, concluded:

We believe gold's role extends beyond affording protection in extreme circumstances. In previous studies, the WGC has shown that including gold in a portfolio can reduce the volatility of a portfolio without necessarily sacrificing expected returns. However, we now find that portfolios which include gold are not only "optimal" in the sense of delivering better risk-adjusted returns, but that they can also help to reduce the potential loss. Specifically, we show that gold can decrease the Value at Risk (VaR) of a portfolio. We find that even relatively small allocations to gold, ranging between 2.5% and 9.0%, help reduce the weekly 1% and 2.5% VaR of a portfolio by between 0.1% and 18.5% based on data from December '87 to July '10. Moreover, looking at past events typically considered to be tail risks, such as Black Monday, the LTCM crisis, the recent 2007-2009 recession, etc., we find that in 18 out of 24 cases (75%) analysed, portfolios which included gold outperformed those which did not. In particular, in the period between October '07 and March '09, an asset allocation similar to a benchmark portfolio, which included an 8.5% allocation to gold, was able to reduce the total loss in the portfolio by almost 5% relative to an equivalent portfolio without gold. In other words, adding gold saved about US$500,000 on a US$10mn investment. – Gold: Hedging Against Tail Risk ,http://www.gold.org/investment/research/

Another study by the same organization, published in April 2011, went even deeper and studied not just how portfolios with gold perform during crises, but in good times as well:

An investor with an asset allocation similar to a simple benchmark portfolio (50% equities, 40% fixed income, 10% commodities) during 2008 would have reduced portfolio losses by between US$200,000 to US$400,000 on a US$10mn investment by allocating 5% to 10% of the overall portfolio directly to gold. Furthermore, over the past 20 years, the same investor would have increased the average annual portfolio gains by between US$100,000 to US$200,000 by directing a similar allocation to gold. These findings suggest that portfolio managers and investors who already have exposure to commodities in their portfolio stand to benefit from including gold as a separate strategic asset class, without compromising long-term returns. – Gold: A Commodity Like No Other ,http://www.gold.org/investment/research/

A detailed study published by Oxford Economics in July 2011 notes similar properties for gold:

...gold performs relatively strongly in a high inflation scenario and also does comparatively well in a deflation scenario derived from a wave of defaults in the 'peripheral' eurozone countries... We find that because of its lack of correlation with other financial assets, gold has a useful role to play in stabilising the value of a portfolio even if the conservative assumption of a modest negative real annual return is made. – The Impact of Inflation and Deflation on the Case for Gold ,http://www.gold.org/investment/research/

While it may seem strange to some that gold appears negatively correlated with other financial assets, considering its history as money this is not so strange. Gold appreciates faster than most financial assets in inflationary scenarios (when central banks are creating new currency) and depreciates slower than most financial assets during deflationary scenarios (market crashes). It acts as a sort of suspension system for portfolios, smoothing out areas of high volatility through countercyclical movements in price.

Due to the strong performance of precious metals, I am recommending it to all of our clients. Because of continued uncertainty in the market and volatility, precious metals will serve as a solid way to preserve and expand the value of our portfolios.

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