Precious metals in investment portfolio diversification

Nothing in life is without risk. If you are in business, there is a risk that a client will not pay an invoice on time. You play games on the computer and put yourself at risk of addiction to the game. You sunbathe on the beach and you are immediately warned that there is at least a risk of sunstroke, etc. In short, we live in a world full of risks, and in the world of investments this is doubly true. Investors know this and therefore try to hedge against the risks in various ways. An effective way to manage the risk of an investment portfolio is to diversify using precious metals.

What is portfolio diversification?

Portfolio diversification is a key principle of investing that helps reduce risk and increase the chances of achieving stable returns. As part of diversification, the investments in a portfolio are divided into different categories and the aim is for a fall in one type of investment to be offset by an increase in another investment category.
 

For proper diversification, it is a good idea to follow a few principles:

• An investor should never invest in one type of asset.

• Investments should be diversified with respect to the economic cycle.

• Investments should cover as many types of sectors as possible.

Investing in stock ETFs is very popular among investors. It can be said that investing in the SP500 index by means of an ETF that replicates this index is already a partially diversified investment, because it includes the 500 largest US companies that do business in different sectors.
 

But what if the stock index falls, as it did, for example, during the COVID-19 pandemic?

Then the investor has other options for diversification:

• Investing in bonds - U.S. government bonds have traditionally been viewed as a safe haven that has held its value relatively well in times of uncertainty in the past.

• Real Estate Investments - these tend to have steady returns over the long term. The downside is the higher capital requirements. But this can be addressed by crowdfunding or investing in a real estate fund.

• Investing in precious metals such as gold, silver and possibly platinum and palladium.

An example of a conservative portfolio that is:

• 30% U.S. equities,
• 40% long-term U.S. government bonds,
• 15% intermediate-term bonds
• and 7.5% gold and 7.5% other commodities is shown in the following figure.

_{Distribution of investments in the conservative portfolio. Source: www.optimizedportfolio.com}

The meaning of such a diversified portfolio is then shown in the following table, which compares the performance of a diversified portfolio (denoted as AWP) over the period 2002 to 2022 with a traditional 60/40 portfolio of 60% stocks and 40% bonds and the SP500 index:
 

_{Performance comparison of the diversified portfolio with the SP 500 index. Source: www.optimizedportfolio.}

At first glance, it is clear what the main advantage of AWP's diversified portfolio is. Max drawdown was the lowest of the options. While the SP 500 index fell 50.97% from its peak, the portfolio lost 21.45%. On the other hand, it is also true that a diversified portfolio has a lower return. In this case, an initial investment of $10,000 over the period for the AWP portfolio would have appreciated to $38,541. However, an investment in the SP 500 Index would have appreciated to $67,227.

This result confirms that the objective of portfolio diversification is to minimise potential losses while maintaining a certain level of return.

The role of precious metals in the portfolio

Precious metals are metals that are characterised by low market supply due to the fact that their resources are limited in nature. These include metals such as gold, silver, platinum and palladium. These metals have a wide range of industrial uses or are used as bank reserves (gold), so they are in high demand. This, combined with limited resources, puts upward pressure on their price and therefore these metals have a place in the portfolio. However, this growth needs to be understood in the long term, which can extend over several decades.

As for the relationship between the performance of gold and the DJ30 index over the last 30 years, this is illustrated in the next figure:
 

_{Comparison of the DJ30 index (blue) and gold (orange). Source: www.macrotrends.net}

It can be seen that in periods when the index has fallen significantly, the value of gold has risen. Gold therefore acted as a cushion during these periods. This can be seen especially in 2001 (dot com bubble), 2008 (financial crisis) and then 2020 (covid-19). Conversely, in times of a strong bull market in equities, we see a decline in the value of gold, as in the period from 2012 to 2016.

We also see that the total appreciation of the stock index has been almost 900% over the last 30 years, whereas gold has appreciated 400%. In short, stock indices can deliver higher returns, but they are also much riskier than, say, gold.

Conclusion

As you can see, portfolio diversification is crucial for investors. A portfolio that is well diversified across asset classes can well weather the market turbulence, economic and political upheavals that always occur in society from time to time.

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