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Gold Has Role As 'Insurance' In Investment Portfolios

By: Allen Sykora, Kitco News

The gold market these days is filled with speculators and investors who wonder just how high the metal will run, and thus how large of a profit they can capture before exiting.

Gold has been in a bull market for more than a decade now, boosted by an expansion of money supply around the world, worries about currency debasements and underpinned by a slew of crises, most recently the civil unrest in the Middle East-North Africa region and European sovereign-debt issues.

But even when the world is in good times, gold has a role in portfolios that may be overlooked by some – as “insurance” against so-called bad times that can suddenly come about quickly, some gold-market veterans say.

“Gold should be like your car insurance,” said Frank Holmes, chief executive officer with U.S. Global Investors, which manages a number of natural-resource funds. “You want to know you have it, although you don’t want to go get in a car accident so you can make a claim on it.”

Olivier Garret, chief executive officer of the independent advisory firm Casey Research, suggested investors not completely leave physical precious metals whenever they think there are no more global worries to keep pushing prices higher. He made an analogy that somebody would not cancel health insurance because he thinks he is healthy.

“Even in good times, you should have it because situations change,” he said. “If you wait until the situation gets worse, then usually the premium is higher…When you have insurance, you have it all of the time. At times, when things become more threatening, you may want to assess whether you have enough insurance. But we think it’s something people should hold, as insurance, at any time.”

Gold is no longer undervalued the way it was roughly a decade ago when it was back around $250 an ounce, he said. Some viewed gold as “an old relic” back then, forgetting that it had been a stable source of money for some 5,000 years.

“It was really an opportunity to buy gold as an investment and something that had to go up, not just in nominal terms but in real terms,” Garret said. “It was undervalued. Today, I don’t think you can say that gold, in real terms, is undervalued.”

Yet, it’s worth holding for insurance, he continued.

One reason, he said, is the expansion of the money supply in the U.S., Europe, China and Japan in recent years. Gold offers protection against currency depreciation and inflation.

Holmes called gold “the bedrock of money.” The reason: “it takes a lot of money and manpower to get an ounce of gold--to move a ton of rock and grind it out…versus pushing a button and printing $1 billion.”

Additionally, gold offers protection against crashes in financial markets such as occurred in 2008, Holmes and Garret said. In that crash, gold did initially slide. “But relative to other classes of assets, it was the class least affected by the financial crisis,” Garret said

Furthermore, the initial decline was because investors “hurting elsewhere” had to liquidate some of their gold positions to raise cash. Afterward, gold rebounded quickly, Garret continued.

In fact, Holmes said, during any 12-month period over the last decade, gold was less volatile than the S&P 500 Index. Thus, he said gold offers “portfolio insurance,” particularly when there are imbalances between government fiscal policies and the monetary policies of central bankers.

“If you look at the history of the world, gold is insurance against all kinds of political threats,” Garret said. “Whenever you see countries in turmoil, people fly back into gold…In the ‘20s in Germany, people who saved gold and exported it were in a much better situation.”

When turmoil does occur, such as the 2008 financial crisis, it can be hard for investors to buy physical metal, and premiums rise, he said. More recently, gold premiums soared in Greece when that country was hit by a debt crisis. The same is occurring currently as Japanese citizens try to buy gold amid the havoc created by a massive earthquake.

Casey Research anticipates there will be another leg of the economic weakness that will be more severe than in 2008. “As a result of that, we are very, very bullish on gold, not because we’re gold bugs, but because we think it’s the ultimate insurance against turmoil.”

How Much Gold Investment For Insurance?

Holmes and Garret offered their philosophies on how much gold investment to hold for insurance purposes.

Holmes favors an annual rebalancing in which the amount remains around 10%. Further, he favors 5% in gold itself and 5% in stocks of unhedged gold companies.

Suppose gold investments in a portfolio rise 30% but the other assets decline 5%. “You should sell down to the 10% level (for gold investments), so you always have that 10%,” he said.

Conversely, when equities are booming and gold lags, Holmes favors taking some profits out of the stock market and buying more gold as “insurance” to get back to the 10% threshold for protection from tumbles in the broader markets. “It’s prudent to have 10% exposure to gold, and you rebalance each year to maintain that,” Holmes said.

He listed an example of the benefits of keeping portfolios balanced. If $1 were put into the Goldman Sachs commodity index back in 1971, this would have grown to $34 at the end of December. If $1 had been put into the S&P index, it would have grown to $41, half of which would have been from dividends, Holmes said.

“But had you put 50 cents into each of those in 1971, and you rebalanced every year and maintained the 50-50, your portfolio would be worth $52,” he said.

In times of global uncertainty such as currently exist, Casey Research favors holding as much as a third of a portfolio in gold—not necessarily all physical gold and silver but also some in other assets such as mining stocks or exchange-traded funds for mining stocks. In good times, when currencies are stable and alternative investments are attractive, one might scale this back to maybe 10%, Garret said.

“But I don’t see those good times coming back any time soon,” he said. “I think the world’s governments are in a race to the bottom to debase their currencies.”

Garret commented that some forms of gold investment are just that – investment rather than outright insurance. As examples, he listed gold futures or shares in gold mining or exploration companies.

“If you buy gold as insurance, you want to have physical gold,” he said. “It can be in allocated storage, or possibly in an unallocated pool if you do it with a reputable company. But it certainly has to be physical gold.”

By Allen Sykora of Kitco News; asykora@kitco.com

Posted Friday, March 25 2011