What about Gold?

Posted on August 14, 2011 by

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it’s a great hedge, but there are risks

You’ve probably noticed that gold is hitting new highs.  If you own it, you might be wondering if you should sell it.  If you don’t own it, you might be wondering if you should buy.

The value of gold as a hedge

The gold ETF (GLD) in blue, and the market (SPY) in red, have both increased in value since 2008

Gold has two qualities that make it an almost perfect hedge against the overall market:  First, in terms of daily returns it’s anti-correllated with the market, which is to say, when the market goes down, gold goes up (and vice versa). Holding gold can protect your portfolio against a sudden, significant drop in the market. Second, gold has consistently increased in value for years (see chart).

If you had held half your portfolio in GLD and the other half in SPY  your performance would be a nice smooth diagonal line up and to the right since 2008. GLD and SPY are ETFs that track the price of gold and the S&P 500, respectively. That performance carries through the recent unpleasant weeks of early August, 2011 related to the congressional debate on the debt ceiling.

Gold did decline in 2008, but not as significantly as the market overall. If you had held gold through 2008, your portfolio would not have dropped as significantly as if you were in stocks only.

Gold is anti-correlated with the market because it has intrinsic value that isn’t subject to failure the way paper assets like corporations and governments are. “Gold will never go to zero” as G. Gordon Liddy says on a TV commercial. When there is panic, gold is one of the places investors put their money in a flight to safety (US debt is one of the other places).  They sell their stocks, depressing stock prices, and buy gold, elevating gold’s price.  On the other hand, when things calm down, and folks feel safe to enter the market again, they sell their gold to raise cash for stocks.

The second quality that makes gold a good hedge — that it always goes up — is a little more difficult to explain. Here’s one theory. Another theory is that gold is the ultimate bubble that will eventually implode. George Soros is among those who think it’s a bubble.

OK, but should I own gold?

My view is that it’s important to own gold, both for its hedge value, and as a diversifier. But I caution against holding too much gold. A portfolio with 5% to 10% in gold is appropriate, but much more than that is too significant an exposure to the “bubble” risk. If you hold more than 10% of your holdings in gold, you’re a speculator. Speculation is only OK if you’re willing to be diligent and be alert for the danger signs I outline below.

How to buy gold

The easiest, most liquid, and safest way to buy gold is with through your stock broker using an ETF like GLD or IAU. Don’t buy gold from those shysters who sell “physical gold” on TV (sorry Mr. Liddy).

Why not? Several reasons. First, they charge outrageous commissions, typically 1% on both the buy side and the sell side. Second, physical gold is illiquid. When its time to sell, you don’t need the hassle of digging it out from under your mattress to FedEx it to the dealer. When its time to sell gold, you need to be able to get out post haste.

When to exit

Whenever you enter a position you should have a specific goal for that equity in your portfolio, and a theory about how it should behave. When your goal is satisfied or no longer appropriate, it makes sense to exit. It’s also important to exit when the equity price behaves differently than you expected it would.

In this case, a reasonable purpose for gold is to serve as a hedge against other components of your portfolio. It is also reasonable to hold gold speculatively; as long as you monitor it closely.

Now, in terms of the behavior of gold prices, recall my assertion that gold is anti-correlated with the market. As long as we see that relationship in daily trading our assumptions about its behavior remain valid.  It’s also OK for gold and the market to move together on light volume days.

The big warning sign: If gold and the market move down together on large volume days, something’s wrong. This isn’t supposed to happen, at least under our assumptions about why gold is a good hedge. If I see this happen more than two days in a row, I’ll exit gold.

What about other precious metals?

Besides gold, one can invest in other precious metals like silver, platinum and palladium — there are ETFs for these metals too. These metals sometimes behave like gold, but not always. Today for instance (August 15, 2011), the DOW is up, gold is down but silver and platinum are up.

The bottom line is that only gold acts like gold. The other metals have industrial uses that also affect their price. You may want to invest in them, but consider them separately from your gold investment.

disclosure: I hold GLD in my portfolio.

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