Posts tagged Gold

Canadian Couch Potato recently interviewed Rick Ferri who had some comments on gold.

He’s made these comments over the years but I think he misses the point or doesn’t want to get the point. Gold is just one asset in a diversified portfolio. It is not the only thing an investor should own. Gold should be used to diversify the unique risks that affect stocks and bonds. That risk is high inflation. Gold is unequaled in its ability to resist high inflation.

Gold offers powerful diversification against currency problems. You don’t need the end of the world for gold to provide diversification in a stock/bond portfolio. The stock market had essentially no real returns for the decade of the 1970s after inflation. Yet, gold helped provide real returns in a portfolio over this time and it didn’t require removing the Cosmoline from your buried AK-47 to battle roaming biker gangs.

In the 2000s we have had a massive growth of overseas and domestic spending which is inflationary despite the recent talk of deflation due to the housing market crash (Have your gas prices gone down over these years? How about your health insurance? School tuition? Me neither.). Yet, again the world did not end. Stocks however have turned in another decade of poor performance barely matching inflation even to today’s date. Adding some gold to a portfolio would have provided real returns over stocks and also reduced volatility improving risk adjusted returns overall.

You can take a bunch of bricks and pile them in your backyard and look at them every day and say, ‘Go up in value, go up in value.’ But you can’t say, ‘What kind of dividends are my pile of bricks going to pay me this year?’ Because it’s zero. How much interest am I going to get from my pile of bricks? None. Is my pile of bricks going to become two piles of bricks over the next 10 years? No, it’s going to be one pile of bricks a year from now, 10 years from now, and a hundred years from now. You’re just hoping that someone comes along who thinks that pile of bricks is worth much more than you paid for it. – Rick Ferri, Portfolio Solutions

Several things:

1) Central banks of most major governments hold gold in their vaults. Many governments have restricted the sale of gold bullion for their own citizens (including the US). Gold has also been confiscated in the past. This is curious behavior for a material that is worthless or no more valuable than cement bricks.

2) When paper assets are being impacted by falling currencies investors will turn to hard assets to protect their wealth. Hard assets remain well after inflation has ravaged paper. Gold is a leading hard asset to own because it represents a compact form of wealth that has been used as money for thousands of years of human history. It is very liquid and seen as valuable just about everywhere on the planet.

3) The price growth of gold has provided excellent rebalancing opportunities to buy stocks when they were on sale in 2008, 2009 and into 2010. Gold has provided those that hold it in a portfolio with strong diversification through volatile markets and gains beyond just the price appreciation of gold alone. It has done this by allowing gold investors to buy stocks when they were very cheap with gold profits.

If I am going to have commodity exposure, I would rather own the companies that make money from commodities. Because the company can become more productive or more efficient. The company pays dividends. The company can make money even when the underlying commodity isn’t. There are times when gold does much better than gold mining stocks, but in the long run you’re much better off buying precious-metal mining stocks – Rick Ferri, Portfolio Solutions

Gold mining stocks are not the same as gold bullion during times of currency problems that are affecting the markets. They also do not provide the same diversification of gold in certain bad markets. In 2008 gold mining index funds lost more than 70% of their value at their worst. Gold was up +5%.

This chart shows what happened in 2008. The blue line is gold bullion, the red line is a gold mining stock index (Ticker: XME):

Precious Metals and Mining Index vs. Gold Bullion

Stocks are not the same as physical bullion. It doesn’t matter what the stocks are. Stocks share the same risks with each other regardless of what sector they cover. When the stock market is doing very badly it will usually affect all stocks. A market that is very bad for stocks may be very good for gold bullion or vice-versa.

Does Rick Ferri Have a Better Strategy?

No, he doesn’t. Rick Ferri seems to be attacking the strategy of holding gold in a portfolio. So let’s see if his diversification strategy is any better.

He advocates a generally high stock allocation. And, among other things, investors hold preferred stocks, high yield bonds (aka. “Junk Bonds”) along with emerging market debt in the bond allocation. These are high risk plays that contribute nothing but trouble for diversification.

How exactly holding bonds from Mexico, Russia, Ghana and companies with bad credit helps diversify and lower my risks is puzzling to me. Maybe you can figure it out. Gold may be risky in its own way, but I fail to see it as any more risky than Mexican bonds.

But, since we’re talking strategy, here’s a sample of how junk bonds of the kind Rick Ferri recommends diversified your portfolio in 2008 when compared against the US Treasury Long Term Bonds that Harry Browne advised for the Permanent Portfolio. Browne always recommended avoiding credit risk with your bonds and cash allocation. Rick Ferri thinks credit risk is a good idea.

The red line represents a junk bond fund. The blue line is the iShares Treasury Long Term Bond fund (Ticker: TLT).

In that year we also had non-Treasury money market funds break the buck freezing redemptions as the credit crisis hit even these “safe” assets. Investors lost their shirts as their cash reserves took punishing losses during the bankruptcies. Ferri’s emerging market bonds didn’t do much better that year losing around -10% to -15%. Chasing yield and taking credit risk with your bonds and cash is a bad idea. But this is the strategy Rick Ferri recommends. Caveat emptor.

Assets in Isolation

Overall, Rick Ferri makes the classic error of looking at assets in isolation when considering gold. Yet his own approach to diversification isn’t any better and in many ways is worse. It’s worse because he takes risk where you don’t want it (in bonds) and avoids it where it can do more good (such as using hard assets to diversify stock/bond risks).

Diversification is about owning several assets with different risk profiles that, when combined, make a portfolio less risky overall and can even help returns. Gold does that when mixed with stocks and bonds. These other assets? Let’s just say I’m not going to trade in my worthless yellow metal for the security of Sri Lankan bonds.

The argument of holding gold in a portfolio is separate from whether gold at today’s prices is a good or bad deal – Nobody knows that because the future is not knowable. It is an argument that gold works in a diversified portfolio when rebalanced as needed. Gold is not a replacement for stocks and bonds in a portfolio. But then again stocks and bonds are not a replacement for gold either. Each asset has its place and time to perform and each has unique risks.

Overall, Ferri’s opinion on this matter flies in the face of decades of empirical evidence in regards to the how gold can work in a diversified portfolio with stocks and bonds. It may not be an asset he likes, but for people who are full up on bonds from Indonesia, Colombia, and Enron, it’s something to consider.