Monday , 24 October 2016

Your Portfolio Isn’t Adequately Diversified Without 7-15% in Precious Metals – Here’s Why

The traditional view of portfolio management is that three asset classes, stocks, bonds and cash, are sufficient to achieve diversification. This view is, quite simply, wrong because over the past 10 years  gold, silver and platinum have singularly outperformed virtually all major widely accepted investment indexes. Precious metals should be considered an independent asset class and an allocation to precious metals, as the most uncorrelated asset group, is essential for proper portfolio diversification. [Let me explain.] Words: 2137

So says Robin Cornwell ( in edited excerpts from his original research report*.

[Lorimer Wilson, editor of (A site for sore eyes and inquisitive minds) and (Your Key to Making Money!) has edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) the article below for the sake of clarity and brevity to ensure a fast and easy read. The report’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.]

Cornwell goes on to say in the executive summary, in part, that:

The objective of this report is to clearly demonstrate that one of the most important investment categories; namely, precious metals (gold, silver and platinum) otherwise referred to as bullion, is an asset class of its own. We further assert that modern portfolio managers, investment advisors, the financial institutions employing these investment professionals [and individual investors alike] are, in fact, not sufficiently diversifying their client’s [or their own] investment portfolios by excluding bullion as an asset class.

The definition of diversification maintains that a balanced investment portfolio should have various weighting of asset classes to be properly balanced. Furthermore, modern portfolio theory tells us that having the right mix of uncorrelated assets reduces risk and improves return. If that is the accepted practice, then why is it that the most negatively correlated asset group to stocks and bonds; namely, precious metals or bullion, has generally been excluded from portfolio diversification as an asset class?

By bullion, we are referring to physical bullion and not a bullion proxy such as the ownership of a mining stock or other alternative investment vehicles. Over the last ten years, the three precious metals have outperformed equities by almost 4 to 1. Where traditional portfolio thinking went wrong was in the belief that commodity stocks and other alternative investment vehicles were a sufficient proxy for physical precious metals in investment portfolios but, in reality, these so-called proxy investments come with significant risks disassociated with the ownership and performance of bullion itself and do not necessarily provide a direct or pure asset class exposure to commodities. We contend that these so-called proxy investments add uncertainty as they expose portfolios to other variables such as financial, geographic and political risks which are then layered on top of operational and management issues.

Physical bullion, on the other hand, provides:

  1. insurance against failure of all other investments,
  2. better liquidity and is the only asset class (excluding cash) with
  3. a positive correlation coefficient with inflation, and therefore, the only asset class that can provide
  4. protection from a systemic crisis.
[It is unfortunate that] many investment professionals do not recognize precious metals as an asset class. A direct physical allocation in precious metals provides an unencumbered investment with (i) no counterparty risk, (ii) sufficient liquidity for large investors, and (iii) no dependence on management for performance.

Once accepted that physical precious metals or bullion should be included as a necessary asset class, then the question becomes just how much of an allocation to physical precious metals or bullion is adequate. Based on historical efficient frontiers, Ibbotson found that including precious metals moderately improved the efficient frontier… [but] based on forward-looking efficient frontiers, Ibbotson found that including precious metals led to asset allocations with higher Sharpe ratios. It was determined that investors could potentially improve the reward-to-risk ratio in conservative, moderate, and aggressive asset allocations by including precious metals with allocations of 7.1%, 12.5%, and 15.7%, respectively.

The allocation to precious metals does not come at the expense of any single asset class, but rather from a reduction in several asset classes. Ibbotson suggests that the unique risk and reward profile of precious metals may make them a useful diversification tool in strategic asset allocations moving forward.

We contend that precious metals should be considered an asset class of its own and that an allocation to precious metals, as the most uncorrelated asset group, is essential for proper portfolio diversification.


Modern portfolio theory tells us that having the right mix of uncorrelated assets reduces risk and improves return. A theory pioneered by Harry Markowitz back in 1952 states that it is possible to construct an “efficient frontier” of optimal portfolios offering the maximum possible expected return for a given level of risk. One of the critical aspects to this theory is achieving the right mix of investments or, in other words, ensuring portfolio diversification with uncorrelated assets.

Merriam-Webster defines diversification as to make diverse or to balance (as an investment portfolio) defensively by dividing funds among securities of different industries or of different classes. defines diversification as a technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not correlated.

A portfolio that is invested in multiple instruments whose returns are uncorrelated will have an expected simple return which is the weighted average of the individual instruments’ returns. Its volatility will be less than the weighted average of the individual instruments’ volatility. An investor can reduce risk simply by investing in many unrelated instruments.


Most pension fund managers, investment professionals [and individual investors] use asset allocation to achieve diversification in order to reduce risk, maximize performance, and thus responsibly manage their client’s [or their own] funds. The traditional view of portfolio management is to break portfolios into three asset classes, most commonly being stocks, bonds and cash, as sufficient to achieve diversification…Surprisingly, the Canadian Banks Forum is an exception…more accurately defining 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. Furthermore, it states that because markets are constantly changing due to the unstable global climate, investors should examine and, if necessary, rebalance their asset allocation annually.

Stocks, bonds and real estate assets provide an ongoing source of value that can be determined using the present value of future cash flows. Commodities are consumed and do not provide a source of ongoing cash flow but rather a single cash flow. Currency, fine art and collectibles are not consumed and do not generate income but do have a monetary value.

The traditional portfolio management thinking has resulted in a surprisingly small allocation of investment funds to precious metals. Pension fund holdings, for example, have less than a 1/3 of 1% in gold, of which half of that amount is invested in gold mining stocks. What should then become obvious is that traditional portfolio managers using the only three asset categories have clearly not sufficiently diversified client portfolios. Not only have they ignored one of the best performing asset classes, but additionally they have missed out on the concept of adequate diversification keeping in mind that precious metals were the most uncorrelated asset class. What is even more amazing to us is that the major financial institutions still adhere to this traditional investment philosophy.


Portfolio managers, investment advisors [and individual investors] should be concerned [with the fact that] gold, silver and platinum have each singularly outperformed several major widely accepted investment indexes over the last 10 years….

Investment professionals have a fiduciary responsibility to meet liabilities for pension plan and future retirement needs of their clients by managing the funds in a responsible and competent manner. To completely ignore the best-performing asset category for such an extended period clearly shows that client portfolios have not been sufficiently diversified. (We do not include bullion proxies such as mining and metal stocks as they expose portfolios to other risks not associated with the performance of bullion itself.)


A study done by Ibbotson Associates (“Ibbotson”) in 2005 determined that precious metals are the most negatively correlated asset class to stocks and bonds. This study clearly made several important conclusions that portfolio managers and investment advisors, including those at large banks and trust companies, seem not to understand or choose to simply ignore.

The goal of the study was to explore the role of precious metals in a strategic asset allocation. An investment in commodity-related stocks does not provide a direct or pure asset class exposure to commodities, specifically precious metals. Therefore, the risk and return characteristics of a direct physical investment in precious metals were explored by constructing an equally weighted composite based on gold, silver and platinum bullion spot prices referred to as the Spot Precious Metals Index (“SPMI”). The SPMI was then used as a proxy for the precious metals asset class. The Ibbotson study examined the 33-year period from February 1971 to December, 2004 and determined that the correlation coefficients of annual total returns of various asset classes compared to the U.S. large cap stocks was as follows:

  • precious metals:** -0.10
  • cash: 0.04
  • US intermediate bonds: 0.22
  • US long-term bonds: 0.28
  • international equity: 0.59
  • US small-cap stocks: 0.79
  • US large-cap stocks: 1.00

**equally weighted composite index using gold, silver and platinum bullion for comparison

Particular detail in the Ibbotson study was directed to the correlations of precious metals with the traditional asset classes and how this relates to diversification. The Ibbotson study pointed out that for the period 1926 to 1969, the correlation between annual total returns for U.S. stocks and U.S. bonds was an attractive -0.02. However, more recently, the U.S. stock market and U.S. bond market correlations have increased. This is reflected  in the 10-year rolling correlations from 1970 through 2004 that ranged from -0.03 to 0.80. Ibbotson concludes that the primary method for improving the risk-return characteristics of the efficient frontier is to expand the opportunity set of available asset classes.

Ibbotson found that over the 33 year period, the equity asset classes outperformed the other asset classes and that the overall performance of the SPMI was closer to the fixed income asset classes. While the standard deviation of the SPMI was quite high in isolation, according to modern portfolio theory, it is the interaction of the asset classes with each other that provides diversification.

Of the 33 years of annual data,

  • there were 9 years that the U.S. Large Cap stocks had negative returns. During this period, the SPMI had the highest average arithmetic return.
  • Furthermore, there were 6 years that an equally weighted portfolio of traditional asset classes had negative returns.
  • The average arithmetic return of the portfolio of equally weighted traditional asset classes for these 6 years was negative 3.5%.
  • For the same six years, the arithmetic return of the SPMI was a positive 13.4%.

Precious metals provided positive returns when most needed.

Of the 7 asset classes mentioned above the precious metals asset class is the only one with a negative average correlation to the other asset classes. As we point out, low correlations between asset classes are essential for diversification.


All major currencies have declined relative to gold over the last ten years [by +80%]. Cash is not ‘king’ as many portfolio managers would have you to believe. From this perspective, the best investment strategy for long-term investors seeking low risk secular growth potential is unencumbered physical bullion.


Ibbotson found that from May 1973 to August 1984,

  • the SPMI was the top performing asset class with the longest run of any of the asset classes in the 11-year period.
  • During the low inflation period, the SPMI had the lowest compound annual return, however,
  • during the high inflation period, the compounded annual inflation rate was 8.6% and
  • the SPMI had the highest compounded annual return of 20.8%.

For the period studied, Ibbotson found that precious metals provided a substantial hedge against inflation. Excluding cash, precious metals is the only asset class with a positive correlation coefficient with inflation and, therefore, the only asset class that can provide protection from a systemic crisis.

*You can access the full report from Catalyst Equity Research here.

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