Gold for the "Man on the Street"

[Austen Heller]

Here is an article printed on Bloomberg Businessweek that describes some of the history surrounding the introduction of the GLD gold ETF.  I found this entertaining, and disconcerting.  Gold seems like a great inflation hedge, but is today's high price being driven primarily by the previously uninvolved wave of ETF buyers?  Would the price of gold be different in a world without the ETFs? Or do the ETFs just amplify the volatility without drastically affecting the gold price?

http://www.businessweek.com/investor/co ... 611772.htm

It was time to get investors to buy a precious metal they'd shunned for a generation, Christopher Thompson, the World Gold Council's new chairman, told him that day. The key was dividing bars of gold into securities tradable on the New York Stock Exchange. He wanted Burton to lead the effort, in no small part because of his connections with institutional investors. Gold was then trading at about $328 an ounce in London.

"I was convinced that there was a market for the man on the street who would buy a lot of gold if he could find an easy way," says Thompson, 62.

History shows that when the price of an asset takes a parabolic climb like gold's has, it's eventually bound to crash, according to Mark Williams, an executive-in-residence and master lecturer at Boston University's finance and economics department. And when it does it's almost always the smaller, individual investors that get out too late, he said.

As much as half of the gold in exchange-traded funds may be held by individual investors, according to BlackRock, the world's largest money manager.

"Your little guy is going to get hit by the doorknob on the way out," Williams said.

When it worked to create the fund, one concern was that the exchange-traded product might contribute to a bubble. Burton and his investment team worried that too much success would shoot gold prices up too fast, resulting in a crash like the one that occurred in January 1980, he said. Back then the bubble burst in one day and took two decades to recover.

Ultimately those engineering what would become SPDR Gold decided it wasn't their job to worry about it.

"Our primary mission was to find every button we could push to stimulate demand," Burton, 59, said in an interview in London. "We also knew that we had launched something that we could not control."

What if the funds were so successful that gold went into a bubble?

"There was a potential perfect storm scenario where suddenly gold would fall into the clutches of hedge funds and momentum traders in very, very aggressive, leveraged plays, which could spike the price and then drop the floor out from underneath it," Burton recalls of the talks.

"Our biggest concern was it would burn another generation of investors and you'd start the whole goddamned tale of tears over again," he says.

[craigr]

Worst case scenario:

Gold drops to $0

How does that affect the portfolio? With a 25% allocation you are, at worst, down -25%.

But what are the odds of that happening?

Further, what are the odds that your stocks or bonds wouldn't go up a lot to offset such an event?

Let's say the drop is 50% from here back to $700. A -12.5% loss. Not great, but hardly a life destroying event for most I suspect. Again though, what are the chances the stocks and bonds couldn't take up the slack?

I don't worry about this stuff. People that need to worry about it are those with very large exposure to individual assets. Gold bugs and stock bugs with heavy allocations to their pet assets are the people that need to be concerned with concentrated positions taking large losses.

[Jan Van]

And (emphasis mine):

His research shows gold has underperformed stocks, bonds, bills and even real estate over the long run. It has total real returns of just 0.6 percent per year since 1802, compared with 6.6 percent for stocks, 3.6 percent for bonds and 2.8 percent for bills. One of the only things gold has beaten is the dollar, said Siegel.

Unlike assets such as oil or wheat that are consumed based on economic factors, gold's true value is difficult for ordinary investors to judge, Siegel said. Its worth is often determined by fears of inflation or financial collapse, he said.

"If you can judge how these investors will evaluate those fears, you will do well," he said.

[craigr]

Worst case scenario:

Gold drops to $0

How does that affect the portfolio?

If you rebalance at 40% bands (<15% weight, >35% weight) across a progressive decline towards gold = $0, that would drag down the whole portfolio around -95% assuming the other asset prices remained unchanged.

i.e. you compound (add) into the decline. Only if you never rebalanced would the loss be limited to -25% worse case.

Gold isn't going to zero so I just don't worry about this. But your point is valid in the sense that rebalancing too much is not necessarily a good thing. I recommend checking a portfolio infrequently and rebalancing the minimum amount needed to maintain bands.

I still think a gold crash is not a long term big deal for the portfolio. This is true only if you aren't timing the markets and maintain positions in all the assets all the time.

[craigr]

Playing devils advocate

If gold was $1350 and you invested $25K in each of stocks, gold, LT and ST, and stocks, LT, ST all remained unchanged whilst gold depreciated in price over the next couple of years down to $486, you might rebalance something like



i.e. a -27.1% decline down to $72.90K fund value from the original $100K fund value due to the decline in gold.

That's somewhat similar/no better/maybe worse than having burnt $25K funds and invested $75K in Stocks, LT and ST's.

What are the chances that stocks and bonds remain unchanged over the next few years while gold drops by 50%+ in value? Pretty low in my opinion.

If stocks, LT and ST rise in price then even more is added into the declining gold price so the loss due to gold could be even higher.

Ok. But we've already had this happen starting in 1981 with gold prices nose diving and staying pretty bad for 20 years. But the portfolio still managed a 3-5% real rate of return the entire time.

But the thing is we don't know what is going to happen. Gold could dive in price, but the appreciation over the past few years has been a tremendous boon as it has allowed holders to purchase stocks very cheaply with gold profits. So we can't single out an asset in a "what if" scenario without also considering the positives it has brought to the portfolio.

Suppose stocks stay in a low trading range the next 20 years as happened in Japan? We just can't predict these things.

[Lone Wolf]

There is a risk that we are at a somewhat similar high gold, low stock stage in the cycle and entering into a repeat of something like the 1980 - 2000 era.  The Gold/Dow ratio certainly suggests such (gold relatively high, stocks relatively low).  Such prolonged relative performance could be a difficult cookie to swallow.

Yep, this is the "PP underperforms in times of prosperity" scenario.  This is a legitimate, ongoing, and valid case where the PP will "merely" protect and grow your wealth while your buddies are cleaning up in their biotech stocks.  I'm sure a PPer had to grind his teeth through many a neighborhood barbecue in 1999.  A strong stock bull market makes the PP's "good" returns just not seem good enough.  If we had a way of knowing when such prosperity was about to occur, we could market time.  (And I especially don't buy the notion that we can know that stocks are "low" or that gold is necessarily "high", although the latter is slightly more convincing.)

It's absolutely fair to bring this scenario up because anyone in the PP is going to face it one day, whether tomorrow or 20 years from now.  However, I balance it against the "stock market goes absolutely nowhere" nightmare that Japan has been grinding on for nearly 25 years.  It's a trade-off that I gladly make.

Also, keep in mind that the "fat tail minimization" cash\stock strategy you mentioned is also going to majorly underperform the stock market in times of prosperity.  Unfortunately, I don't think it's possible to know when to be 100% in stocks and REITs vs. 100% in gold and cash.  You can't get stock's returns (in certain periods) without stock's risks.  IMO.

Fundamentally, I think that you believe that market timing is possible (but I beg you to correct me if I'm misunderstanding you.)  I do not believe that the market can be effectively timed.  (This is why I find momentum-based trading systems very, very unconvincing.)  I think this difference of opinion explains why we come to such different conclusions.

BTW, there is something I just have to ask you.  On the Bogleheads PP thread, you've got about 100 posts that you later deleted.  Most of these posts generated interesting discussion before you killed em off.  What'd they do to deserve that? 

[uncle Lou]

thank you Austen Heller for the post, and thank you Clive for playing Devil's Advocate.

In my mind these are valid concerns. I'm sitting on the sidelines holding the most unloved asset in the world right now:cash

Uncle Lou

[craigr]

My concern is that perhaps you're not capturing all of the error traps and could encounter a retribution bug at some later date as a consequence of not having covered all angles.  So please don't take this to be a personal/counter-productive argument for argument sake.

I understand. I'm not taking it personal. I also ran a business and raised a lot of money doing so and I've learned to adapt to challenges that come up unexpectedly. Business management is not as neat and tidy as programming. That's why I like the Permanent Portfolio. It gives me options to respond to extraordinary events. Gold could drop very hard. It has before. I'll just have to deal with it when it does. But historically the odds on favorite is to rebalance into losing assets.

If anything with the ETFs, it is entirely possibly that the accessibility they created may make gold trade at a permanently higher price than people would think. So I don't know if it is $1400 as it is today, but it could very well be much higher than the $500 some authorities suggest. ETFs make gold available which could be pushing the price up. But on the flip side the ETFs make gold available which may keep the price up higher than they think.

[smurff]

There is an easy way to deal with this concern:  The Variable Portfolio. 

The Permanent Portfolio gets a lot of discussion, I guess, because it's so unique.  But HB also emphasized the importance of the Variable Portfolio.  So while your friends are bragging around the barbecue about all their gains on high-tech stocks, you can brag too, if you believe that was something you wanted to speculate in.  If you chose well for your VP, you'd have a lot to brag about.  An investor who believes that gold (or any other component of the PP) is troublesome can always hedge your investment in the VP, if that's what the investor wants.

Where money is concerned, however, there is much to be said for not bragging, but being discrete.  Besides, how many of the barbecue braggarts are liars?  And besides, many of the gains on their high-tech and internet stocks evaporated over the past decade, as gold, for example, has made a slow increase. 

[Storm]

Along this discussion line, due to the recent rise in gold, many PPers will probably have already hit the 35% rebalancing band.  Now might be a good time to take a look at your portfolio allocation and rebalance out of gold before the end of the year, locking in some profits and buying up some underperforming assets (say LT treasuries, perhaps?).

[craigr]

Along this discussion line, due to the recent rise in gold, many PPers will probably have already hit the 35% rebalancing band.  Now might be a good time to take a look at your portfolio allocation and rebalance out of gold before the end of the year, locking in some profits and buying up some underperforming assets (say LT treasuries, perhaps?).

That's the spirit! I always feel good after rebalancing and putting profits in underperforming assets.

[Lone Wolf]

Thought-provoking as always, Clive!  I remain a total non-believer in momentum-based trading systems but it looks like you've constructed a very solid overall strategy here.

I do think I'd be very nervous having (potentially) no long-term bond exposure whatsoever.  The longest end of your treasury ladder is only the 5-year, which has very little meaningful volatility.  It seems like deflation would stick you down in the dumps, particularly if momentum had pushed your gold holdings up toward 37.5% (or higher) and left you out of LT bonds.

From what I understand, much longer Gilts are available in the UK.  I don't know whether you can get 30-year Gilts but 30-year bonds have worked very well in a United States PP.  A sudden deflationary event (such as 2008 in the United States) left the Permanent Portfolio leaning hard on LT treasuries.  If your momentum system doesn't have you in LT's, 25% in a 5-year bond ladder just doesn't seem like it would cut it.  I think you'd need something to pull hard on the rest of the portfolio in order to keep it stabilized.  I'm afraid in this situation that your portfolio could get beat up.

[moda0306]

The momentum stuff is very scary if you ask me...  It's does hold up amazingly historically, though.  I would think of it as a way to tweak your portfolio, maybe not going all in.

I wonder what a 40/30/20/10 RS portfolio would look like... personally I'd always keep cash at 10%.