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Asset allocation is one of the most
crucial aspects of building a diversified and sustainable portfolio that not
only preserves and grows wealth, but also weathers the twists and turns that
ever-changing market conditions can throw at it. However, while the average
advisor or investor spends a great deal of time carefully analyzing and
picking the right stocks or sectors, the basic and primary task of asset
allocation is often overlooked.
Asset allocation is usually taken for
granted as being a mix of the three main asset classes: stocks, bonds and
cash. Many investors believe that a broad mix of equities (financials,
healthcare, utilities and telecoms), an exposure to foreign stocks, some emerging market plays, some bonds and a foundation of
cash, equals diversification. However, this traditional approach is not only
outdated, but also completely excludes several key asset classes such as foreign
currency, real estate, collectibles, precious metals, natural resources and
life settlements. Also, as Figure 1 shows, the three main asset
classes are all positively correlated. A portfolio that consists entirely of
positively correlated asset classes cannot achieve optimal diversification.
It is not surprising that investors
usually consider only three asset classes; most financial websites still
refer to portfolio diversification being achieved through an allocation to
the traditional stocks, bonds and cash. The Canadian Banks Forum is an exception;
it correctly defines asset allocation as a process whereby an investor
diversifies his or her portfolio with different classes of assets such as
stocks, bonds, cash investments, foreign currency, real estate, collectibles,
precious metals, natural resources and life settlements. It notes that,
because markets are constantly changing due to the unstable global economic
climate, investors should examine and, if necessary, rebalance their asset
allocation annually. Any portfolio that does not include these other asset
classes cannot be diversified and risks ignoring important long-term trend
changes that may occur in the economy.
Long-Term Trends
It is vital to consider long-term
trend changes when planning asset allocation, since economic cycles are not
set in stone. The trend for each individual asset class needs to be evaluated
on a regular basis and adjusted accordingly. What might be an appropriate
asset allocation one year could be completely ineffective 20 or 30 years
later. Yet the traditional stocks, bonds and cash mix, which was popularized
in the 1960s, has been used by the vast majority of advisors and investors
ever since without any consideration for changes in the economic landscape.
Well, a lot can change in the economy in half a century.
Financial markets are cyclical and
history shows us that each cycle usually lasts approximately 20 years, as
seen in Figure 2. Accordingly, it is critical to identify which asset
classes are likely to outperform during the current cycle when deciding
portfolio asset allocation.
The Dow has experienced several
cyclical up and down trends throughout the last century. Identifying which
trend the market is currently experiencing is of paramount importance. For
example, a 60-year-old investor allocating to stocks in 1968 would have been
87 before breaking even, adjusting for inflation, in 1995.
The bond portion of a portfolio
faired just as poorly during the 1970s. Bonds are decimated during periods of
rising inflation, and in the 1970s inflation rose to over 13 percent. A
mutual fund bond investment fared even worse during that decade; the net
asset value of a bond fund drops as inflation takes hold and subsequent
interest rate rises eat into the purchasing power, and then the price, of the
fund.
Perhaps more crucially, a portfolio
limited to stocks and bonds during the 1970s would have missed one of the
greatest commodity booms ever experienced. From 1971 to 1980, gold rose by
2,300 percent, silver by 2,400 percent and platinum by 900 percent, while oil
rose 900 percent.
Changing Times Require Changing Mindsets
Most investors' experience with
investing is based only on the last cycle. They find it difficult to
rebalance their portfolios in order to align them with changing trends,
having become entrenched in one mindset. Successful investing requires
correctly identifying new trends rather than simply assuming the continuation
of past trends. During the past 25 years, the North American stock market has
experienced one of the longest, highest-running bull markets in history, with
the Dow rising 1,100 percent from 985 in 1982 to 11,723 in 2000. However, we
have entered a new cycle, one that includes a long-term positive trend for
gold. Savvy investors today need to adopt a gold mindset.
Just as in 1968, however, today's
investors are complacent. They are convinced that equities will continue to
provide superior returns during the next 20 years. Many feel the financial
turmoil of 2008 is behind us, that the worst is over, and are blindly looking
forward to further gains on the stock market. This mindset fails to
acknowledge today's financial reality.
In fact, economic conditions today
are much worse than in the 1970s. Government spending around the world has
exploded and continues to do so. Fiat (paper) currency supply, along with
government debt in the world's major economies, is spiraling out of control.
The situation is worsening daily, and burgeoning inflation can be the only
result. Crucially, the world's debt will inhibit governments from substantially
raising interest rates- today's economies couldn't withstand a high interest
rate environment.
These are the reasons gold has risen
constantly, year after year for nine years, and will continue to do so. In
truth, gold isn't just rising; fiat currency values are falling through
debasement by their governments. The more dollars created, the less each one
is worth. Gold protects investors against inflation, because it is a
non-depreciating asset.
As we have seen, the world has
changed. Equity markets are topping. From a purely analytical point of view
we can see that equity valuations are high, and there is more potential risk than
reward. It is time to rebalance portfolios.
The Dow:Gold Ratio
The Dow:Gold Ratio, which measures trend changes in the
price of gold versus a basket of stocks as represented by the Dow, supports
the idea that investors today should have an allocation to precious metals.
Essentially, the Dow:Gold
Ratio divides the Dow by the US-dollar gold price. Figure 3 shows that
when the ratio is rising, as it did in the 1920s, 1960s and 1990s, portfolios
should be overweight equities. When the Ratio is falling, as it did in the
1970s and is doing today, portfolios should be overweight precious metals.
Currently the Ratio is 8.18:1 and, equally important, it is falling, meaning
there is still plenty of time for investors to rebalance into gold and
precious metals.
Gold is Money
Gold is money, not a commodity as
many investors and advisers incorrectly view it. Gold trades on the currency
desks of the major banks and brokerage houses, not the commodity desks. It is
a wealth-preserving asset, not a wealth-accumulating asset. We buy and hold
gold bullion to preserve wealth. It is important to note that, while we may
speculate in gold stocks, exchange-traded funds, futures and options to
increase wealth, it is gold bullion ownership that best serves the purpose of
wealth preservation.
Figure 4 shows the
different precious metals investment vehicles based on inherent risk. The
best investment strategy for long-term investors seeking low risk with
secular growth potential is unencumbered physical bullion. As we can see,
bullion forms the foundation of the Precious Metals Investment Pyramid,
because it offers the lowest risk.
We can further illustrate this point
by looking at standard deviation, the most commonly used measure of risk. It
calculates the total risk or variance associated with the expected return.
Simply put, it measures how volatile or widely spread an investment's returns
are from its mean, over a period of time. When annual compounded returns are
plotted against standard deviation, the individual Dow stocks are all more
volatile than gold, and all but one of the Dow stocks have poorer performance
than gold, silver and platinum over the past 11 years (Figure 5). If
we use other common methods of risk/return measurements, the Sharpe Ratio and
the Sortino Ratio, we get the same results. Gold is
less risky and performs better.
Mid- And Long-Term Trends
There are three dominant mid-term
trends that will drive the gold price for the foreseeable future and perhaps
longer than the historic 20-year time frame: central bank buying, movement
away from the US dollar and the effect of the changing mindset in China and
many Asian countries towards gold. We have already seen how fiat currencies
are losing value and being debased. In November 2010, China and Russia
decided to renounce the US dollar and resort to using their own currencies
for bilateral trade; this is an indication that the dollar's reign as world
reserve currency is drawing to a close. In 2009, central banks became net
buyers of gold for the first time in two decades. They understand the issues
facing fiat currencies and are moving to protect their countries' wealth;
they understand that gold is money. The Chinese are one step ahead in terms
of gold. They already have adopted a gold mindset. In the first two months of
2011 the Chinese imported 200 tonnes of gold, as
much as the entire previous year. This was just individual investor demand,
not central bank demand, which we know is also growing.
During a speech at the Empire Club in
Toronto, I spoke at length about these mid-term trends, as well as
longer-term trends, which will support and propel the gold price moving
forward. A transcript of that speech is available at www.bmgbullion.com/document/806.
An Appropriate Allocation
Today's typical "balanced"
portfolio, consisting of 60 percent equities and 40 percent bonds, will
simply lose value year after year in real terms during the coming
high-inflation cycle. This is not even considering any bond defaults or
equities market crashes that may occur due to the precarious financial
situation many economies around the world are experiencing. Dramatic
portfolio rebalancing is required to preserve and grow these portfolios.
According to a study by Ibbotson
Associates, a 7 percent allocation to gold is needed in conservative
portfolios and a 16-17 percent allocation is required for aggressive
portfolios. Those amounts are required simply to have a balanced, diversified
portfolio during stable times, or what may also be known as strategic
allocation.
From a tactical allocation
standpoint, Wainwright Economics looks to gold as being a leading indicator
of future inflation. In a high inflation environment, which the ongoing
currency creation around the world all but guarantees, their conclusion is
that you need 15 percent in a bond portfolio and the same percentage in an
equity portfolio just to insure your investments against further inflationary
damage.
I would suggest that a properly
diversified portfolio today should consist of 25 percent gold bullion, 50
percent in a basket of commodities including precious metals, oil, gas, water
and agriculture, and 25 percent in short-term fixed income.
The percentage mix is debatable; what
is certain, however, is that the historic three-asset-class allocation mix is
outdated, out of touch with today's economic and financial reality and a
recipe for loss of wealth. To protect your portfolio and preserve your
wealth, a 5-20 percent allocation to precious metals is an absolute
necessity.
Nick Barisheff
Bullion
Management Group
Nick Barisheff is the co-founder
and President of Bullion Marketing Services Inc., which was established to
create and manage The Millennium BullionFund. The
fund is Canada’s first and only RRSP eligible open-end Mutual Fund
Trust that holds physical Gold, Silver and Platinum bullion www.bmsinc.ca
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