Make Money In Any Market: Balance Your Portfolio
Mix Your Investment Assets to Reduce Risk
What is a "balanced" portfolio?
Why should mixing different asset classes make your investment portfolio much less risky?
Here is an explanation (and some of the maths) behind this useful risk reduction method. Most portfolios are highly correlated to just the stock, bond or property markets and when disaster strikes all of these markets can fall. Having a mixture of these different investments and other uncorrelated assets such as precious metals however can provide some insurance against this outcome.
Gold and silver are volatile and have had a bad time against the dollar recently (although have performed well when compared with pounds Sterling) but are generally uncorrelated to other assets so they can be used to reduce your risk. Throughout history Gold and Silver have been real money. The dollar, pound, euro and yen are just pieces of paper ("fiat" money) and have no actual value. If the dollar or any other major currency collapses gold and silver should retain their value.
Stock markets are high-risk, but can give very good returns or lose you all of your money, whereas bonds are mostly lower risk and generally not very correlated to stocks and do pay an income, but are far less fun and gold pays no income, but does at least preserve some of your wealth when disaster strikes. A balance between these asset classes and property is usually the best bet. To find out why read on...
Disclaimer: Information in this and other linked articles is unregulated and for general information only and is not intended to be relied upon in making specific investment decisions. Appropriate independent advice should be obtained before making any such decision.
Don't put all your eggs in one basket
This article is for information purposes only and does not form a recommendation to invest. The value of an investment may fall. Investing in precious metals, shares and bonds may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Balanced Portfolio Theory
Buy gold to reduce your risk
A simple rule of investing states that the higher the risk of an investment the higher the return. This is the Risk Premium: The amount you get paid for taking the extra risk. So if you want to make lots of money you need to take more risks. It is however possible to reduce the risk by building a balanced portfolio.
The risk of buying a single share is high with many possible unknown influences on the share-price and future dividends. Buying two shares results in some reduction of risk because a crash in one share price may not affect the other one adversely. Many shares are highly correlated to each other, so having two shares in the same field (e.g. BP and Shell) does not reduce the risk as much as two shares in unrelated industries (e.g. BP and Lloyds) Similarly mixing shares with other asset-classes will also improve volatility of the over-all portfolio (e.g. mixing shares, bonds, property and gold bars)
Skip the maths in the next section if you prefer - this is just for illustration
Some books about gold and silver investing
The Maths (Skip this section if you prefer)
The risk of the portfolio of N assets can be expressed as follows:
Unfortunately these parameters are not readily available so accurately determining the optimum values for relative weights in the portfolio is difficult, but the equation does highlight the importance of uncorrelated assets. As the number of assets increases the value of xi2 gets far smaller and the first term of the equation far less significant and if the covariance σij is small the second term is also small:
If N >> 1 then xi << 1
A portfolio with equally weighted investments in 10 uncorrelated assets would result in a risk of:
i.e. If each asset has equal risk the total risk is just a tenth of the risk of the individual assets. This of course is an extreme example, but does demonstrate the principle.
Insure Yourself Against Devaluation
Many people made the mistake of ignoring the equity, bond and precious metal markets in favour of property, making their portfolio extremely highly correlated to one market, and heavily geared (mortgaged) to improve returns or increase losses. Property may have seemed like a one-way bet, but most people have more than enough exposure to the property market through their own home. Having no exposure to property and a large equity exposure could also be risky, but having a mixture of uncorrelated assets would have reduced the pain of the property market or share market falls. Gold in particular has benefited from the fall in relative value of western currencies.
Financial advisors often provide a range of different suggested portfolio distributions depending on the income requirements and risk profile of the investor, how long before the money is required and what volatility or losses could be tolerated. Generally higher risk portfolios will consist of smaller shares or foreign equities and high-yield or emerging market bonds, income portfolios are usually blue-chip shares and bonds and low risk portfolios mostly government bonds and cash. In all cases mixing many assets with low correlation from different countries and different industries will reduce the risk. Gold is uncorrelated to other asset classes and tends to retain value even when other types of fiat money fall in value.
Many advisors recommend having 5% to 10% of gold, silver and other precious metals in your investment portfolio. This can be in the form of mining shares, ETFs, mutual funds although at least some of it should be in the form of real physical gold. Coins and gold bars can be bought from a broker with a significant premium over the value of the gold, alternatively there are always a lot of gold sovereigns and krugerands available on eBAY for a price close to the actual bullion value of the gold.
How to Get Exposure to Gold and Silver
Buying mining shares, mutual funds (unit trust or investment trusts in the UK) and ETFs can of course be done through a stock broker, coins and gold bars can be bought from a specialist coin dealer, but with a significant premium over the value of the gold, typically more than 10% for small quantities of coins to perhaps as low as 5% for large quantities of low quality bullion coins. High quality or rare coins will be more expensive, but should also retain that extra value.
An alternative and cheaper way to buy gold coins is on eBay, which is very easy and quite low risk. There are always a lot of gold sovereigns and krugerands available on eBAY for a price close to the actual bullion value of the gold.
Another, riskier, method for gaining gold or silver exposure is through spread-betting. I have written a separate lens on how to use spread-betting to reduce portfolio risk:
Pros and Cons of Owning Physical Gold and Silver
So why don't I just buy lots of gold and forget about shares, bonds, cash...?
Gold sounds too good to be true. When other markets and currencies get into trouble gold goes up in value, but there are a few reasons why gold should not make up too large a proportion of your portfolio.
Gold Does not pay a dividend
Shares, bonds and property investments often pay a dividend (or a "coupon" or rent), so even when markets go down you still get an income. Gold does not. It just sits there looking shiny.
Gold needs to be stored
Physical gold in the form of bars or coins needs to be stored safely somewhere. If it is just worth a few thousand dollars you can keep it under the bed and not worry too much, but for large amounts of gold you will need to pay a small premium for storage at a bank or insurance or of course you could buy a safe.
For large investments in gold an exchange traded fund (ETF) can make a sensible alternative (e.g. Lyxor Gold, GBS tracks the value of gold) without the storage hassles.
Investing in Physical Silver
Physical silver is also an interesting thing to buy for investing, but it is worth far less than gold, per ounce, so a significant investment in silver takes up a lot of space. Antique silver however is quite inexpensive compared to scrap silver and could be quite collectable.