Posts tagged diversification

I see this chart posted from Jermy Siegel’s book Stocks for the Long Run from time to time to defend why owning lots of stocks is the way to go and why owning gold is some kind of chump move.

Well I think this chart is misleading for several reasons. Gold is useful in a diversified portfolio along with stocks and bonds. It should not be 100% of a portfolio just as stocks shouldn’t be nor bonds.

First let’s explain a few things about this gold line you see here. We must understand that for the first 130 or so years of the founding of the United States gold and the dollar were the same thing (aka. the Gold Standard). With that, let’s look at this chart with this gold standard in mind:

1) From 1802-1913 the value of the dollar was strongly linked to gold and there was slight deflation over this time. There was essentially no inflation except for the period around the Civil War when Lincoln printed a lot of money to pay for things. That’s the blip you see in the early 1860s. Gold went “up” simply because the dollar was going “down.”

2) In 1933 FDR broke the gold standard. He raised the price from $20.67 an ounce to $35 an ounce to deliberately try to cause inflation. This was done after prohibiting Americans from owning gold. That’s the rise in gold price you see in that year and also when the dollar started to rapidly decline in value. A gold convertible currency prior to that keeps paper currency honest because if people think the government is printing too much money they could turn in their paper dollars for gold specie and drain the Treasury. After 1933 that was no longer possible. This was a stupid idea that achieved nothing but allow the inflation genie out of the bottle and send the dollar on a downward trajectory from that day forward.

3) In 1971, after nearly four decades of artificially low gold prices due to government price controls, Nixon broke the last of the gold standard for foreign holders of dollars. Dollars could now be converted to gold by nobody. You see the gold price spike the first couple years as it adjusted for the prior price controls. After that, I believe it was simply responding to the very high inflation. The dollar also this year begins a very big decline. By the end of the 1970s the dollar bought about only 50% of what it did in the early 1970s. By today it’s lost something around 80% of its purchasing power.

4) Gold is not volatile. It’s a piece of metal. It is only volatile against the currencies it is priced in which are the real culprits. Price spikes in gold are more of a reflection in the value of the dollar than anything. Gold is a form of money and people buy it when they think the dollar is going to have problems keeping its value.

Now back to the chart in general. This chart is misleading for several reasons:

1) The data going back to 1802 is suspect to me. Nobody could have invested that way if they wanted to even if the data is accurate (which is another debate). This chart is what stock bugs use to justify why you only need to own stocks. It’s as bad as when a gold bug shows you a chart of gold vs. the dollar and insists you only need to own gold. No, you need to own a variety of assets like the Permanent Portfolio. Concentrating your bets in any one asset is a bad idea.

2) Nobody lives for 200 years. An investor’s timeline is like 30-40 years before they need the money. Stocks have had extended periods of bad performance in the past and this makes total returns very time dependent on the individual level.

3) Gold doesn’t have interest and dividends. This is a statement of the obvious. But it has much different risks than stocks and bonds and that means it is still useful in a portfolio. The same economic factors that are horrible for stocks and bonds can be quite good for gold and vice versa. That simply means you own gold as part of a diversified portfolio and not 100%.

4) This chart also shows that over 200 years gold has had a remarkably good record of stability in terms of preserving purchasing power. This is quite remarkable when you consider the history of the US, the wars, the booms, the busts, etc. that have happened. How many companies from 1802 are still around today?

5) Gold in a diversified portfolio can increase returns, decrease volatility, decrease risk, and provide protection under serious currency problems. All good things in my book.

This chart doesn’t make the case that gold shouldn’t be owned to me. It basically makes the case that owning a lot of different assets with different risk profiles is a really good idea. Stocks can be very powerful when the economy favors them, but when it doesn’t they can languish with big losses or zero real returns for protracted periods. A portfolio with stocks, bonds, cash and gold however can weather just about anything the economy is throwing at it. Diversification is your friend.