Archive for July, 2009

The Effect of Gold in a Diversified Portfolio – Part 2

Tuesday, July 7th, 2009

Below is a chart of the progress of an investment portfolio starting in 1975 with $1 optimally allocated among ten asset classes including Gold. The magenta line reflects a portfolio always invested in each asset class according to the percentage allocations recommended by Modern Portfolio Theory and readjusted each month. The green line is a better result using a conservative combined market timing strategy that places the investor in the safety of T-Bills for the particular allocation amount that would normally be invested in that asset class when the current performance trend in that asset class is identified as significantly negative.


The results of the above chart holding a Gold component in a portfolio should be compared with the results in the next chart that repeats the same analysis but instead leaves Gold out entirely from potential consideration as a component in the portfolio.


As can be seen, the inclusion of Gold in a portfolio during this period was significantly detrimental to overall portfolio performance. Early 1970’s gains in the Gold asset class were not sustained and the effect of expecting a continuation of this performance was to hold down portfolio value. With Gold included, portfolio value is today worth about 12 to 15 times the initial investment depending on the strategy employed. But without Gold the result is higher at about 18 to 25 times the initial investment. It took until 2000 for those early Gold asset class gains to dilute sufficiently with time to the point where the recommended percentage allocations dropped to zero as seen in the allocation chart in Part 1 of this article.

Some observations:

It should be apparent that the 10% compounded average target return was not achievable over the entirety of this analysis period due greatly, but not entirely, to the recent financial meltdown. The best was a close 9.8% reached by excluding Gold as a component and using the SMC Analyzer’s conservative “Long or in T-Bills” market timing strategy enhancement. Analyses were conducted at target return percentages other than 10% but the results were similar. In fact, the more that the allure of Gold would lead the investor to invest a greater percentage of their portfolio in the metal the better off they would have been to leave it out completely. The failure of Gold to maintain the performance achieved during its first decade of public availability produced actual portfolio returns lower than predicted over the nearly 35 years of the analysis period. Other asset classes have also failed recently compared to their historical performance levels and this contributed to the inability of the recommended allocations to meet the 10% target.

Portfolio risk as measured by the standard deviation of returns was much lower with the inclusion of a Gold component but this is to be expected with the addition of a nearly completely uncorrelated asset class and with the failure of the various asset classes to produce the desired target return. The relationship between risk and reward nearly always holds true. The greater the returns the greater the risk or variation in those returns. The lower the returns the lower the variations.

The relative preservation of portfolio value during the stock market decline of 2000 to 2003 is due to an interesting result of using an asset allocation tool like the SMC Analyzer. When the history of asset class performance is limited to starting in 1970, as we did to be compatible with the start of legal Gold ownership, large stocks as an asset class are deemphasized as an advantageous portfolio component due to their poor returns in the 1970’s. Hence the investor was automatically saved from the decline at the start of this century when the market in stocks tanked. That same principle unfortunately applied in reverse for investment in Gold. It continued to be recommended based upon good 1970’s decade returns even though the overall return for the subsequent 20 years was negative.

Based on this history then it is argued that Gold has not been the sparkling portfolio component that it is frequently touted as being. Gold is sometimes utilized as a form of portfolio insurance. If all else falls then Gold is sure to go up. That is hard to dispute but the cost of that form of insurance has been very expensive.

The future:

So, given that Gold has not worked out for much of the past 30 years what does this mean for the future? Well, with the excellent recent performance of Gold during the financial crisis and the anticipation of high future inflation from all the government money being pumped today into the economy (assuming it actually gets spent) there is once again good reason to take a serious look at Gold. The SMC Analyzer’s recommended percentages for the Gold component have risen like Lazarus starting in 2006. Had you bought a small portfolio component at the $600 price level back then you would be very happy today with the price soaring to over $900 per ounce and this would have mitigated declines in some other asset classes. The current recommendation for the percent of a diversified portfolio that should be allocated to Gold (assuming a 10% overall portfolio target annual return) sits at about 12% today. If inflation once again spikes up, as it is very likely to do sometime within the foreseeable future, that allocation could come in handy as Gold prices soar far above today’s levels.

The Effect of Gold in a Diversified Portfolio – Part 1

Tuesday, July 7th, 2009

First of all I would like to thank Dr. Kris for the opportunity to act as a guest blogger this week while she is away. This article will be about what holding a component of Gold in an investment portfolio means to the overall performance that portfolio returns.

The Midas metal has long been recommended as a component of a diversified portfolio but is that really a good idea and how much Gold, if any, should the investor hold relative to other asset classes? What will be described here are the results of adding the monthly time history of the price of Gold (on the London exchange) to the other nine asset classes already included in the SMC Analyzer offered for subscription on this web site. Briefly, the SMC Analyzer is an enhanced mean-variance optimizer for determining optimum asset class allocations in an investment portfolio along the lines of Modern Portfolio Theory.

Holding Gold bullion as an asset class has several consequences. First of all it returns no dividends nor interest. In addition, holding the metal means that the investor must incur assaying, storage, and insurance costs.  It would actually be recommended that a mutual fund of Gold stocks be used as the investment vehicle for investors interested in including the precious yellow metal in their portfolios. In conducting this analysis however the straight price of Gold was preferred over stocks to provide as pure a commodity play as possible without any possible perturbations from disparate corporate performances.

Some history:

The price of Gold for most of the 20th century was controlled by government regulation and international agreements. Here are some major events.

– In 1900 the Gold Standard Act placed the United States officially on the Gold standard. This meant committing the United States to a fixed currency exchange rate relative to a fixed price of Gold (then at just over $20 per ounce) with other countries also on the Gold standard.

– In 1913 the Federal Reserve Act mandated that Federal Reserve Notes be backed 40% in Gold.

– In 1933, as a response to the banking crisis at that time, the U.S. Government prohibited private ownership of all Gold coins, bullion, and certificates.

– A year later the Gold Reserve Act of 1934 gave the government ownership of all Gold money and stopped the minting of any new Gold coins. Gold certificates could only be held by the Federal Reserve Banks. At that time President Roosevelt reduced the value of the dollar by increasing the price of Gold to a regulated $35 per ounce.

– The Bretton Woods conference, held in 1944 as World War II raged, reaffirmed the regulated price of Gold at $35 per ounce and established an international framework for how the participating nations were to maintain an exchange rate for their currencies relative to that price.

– In 1968 as mounting financial pressures strained this framework a two-tiered pricing system was enacted separating official transactions between monetary authorities (at the regulated price of $35 per ounce) and other private transactions (to be conducted at a variable free market price on the London Gold Market.)

– In 1971 the framework collapsed and the United States officially went off the Gold standard and halted the redemption of foreign held dollars into Gold. This caused a great deal of financial upheaval in the world economy and established the U.S. dollar as the world’s reserve currency.

– At the end of 1974 Americans were finally permitted to privately own Gold other than as jewelry for the first time in 40 years.

The analysis:

Therefore, based on this first year Americans could legally own Gold bullion the starting year for portfolio analysis will be 1975 and history data for the price of Gold will start in 1970 when the free market for Gold came into full swing. The chart below shows how $1 invested in Gold in 1970 has performed since that time. This reflects exactly the variation in the price of Gold from about $36 per ounce in 1970 to today’s price of about $935 per ounce.


To perform portfolio analysis an overall target return must be selected. A compounded average annual return of 10% was selected as being a viable long term goal. Using the SMC Analyzer to optimize portfolio allocations among the various asset classes to achieve a minimum standard deviation of overall returns we obtain the following result for the period from January 1975 through June 2009 for the recommended percentage of Gold as an asset class to be held at each monthly point in time.


The Long/Long oscillator strategy referred to in the figure above indicates that the market timing capabilities available in the SMC Analyzer were not used to generate the above chart. You can see that the percentage peaked during the great bull market in Gold in the 1970’s when inflation raged in the U.S. reaching a whopping 13.58% during 1980. The subsequent generally falling recommended percentages of Gold holdings through 2005 reflect the flat to slightly declining price of Gold resulting from comparatively low rates of inflation in those decades.

This illustrates one problem with the strict application of classical Modern Portfolio Theory. That stellar returns in one asset class (in this case Gold) during one time period, the 1970’s, are treated as though they are still occurring (although being diluted with time) when in fact they are not. The tendency of the recommendations to keep the investor invested in that asset class even though returns are currently poor is a valid criticism of Modern Portfolio Theory which led to the development of the SMC Analyzer’s market timing strategies.

This article will continue tomorrow in Part 2.

Expanding your workspace to include ETFs

Thursday, July 2nd, 2009

On Monday we looked at how to set up your trading workspace such that it will reflect the conditions of the overall market as well as the current state of your portfolio constituents. Today, I’ll show you how you by adding ETFs to your workspace can provide you with a more in-depth view of market conditions.

Using ETFs as sector proxies
There’s an index for just about everything and there’s an ETF for just about every index. You can use the indexes themselves to gauge the state of the market or you can use corresponding ETFs. I prefer the latter approach because if you see a sector that’s breaking out and you want in on the action, you’ll know immediately which ETF to buy.

Here are two workspaces that contain the most widely held ETFs grouped according to asset class. Included in the first workspace are major US market sectors, foreign countries, US corporate and government bonds, and international bonds. I also threw in dividend-paying ETFs since many people play these.

[Click on these to enlarge.]


The second workspace is commodity-oriented. It includes an overview of commodities plus specialized quote sheets devoted to currencies, energy, and metals.


Of course, the ETFs I’ve mentioned here are just the ones I use, but of course you can use your own if you prefer. The only caveat is to beware of the Merrill Lynch HOLDRs. They are fixed baskets of stocks that become less representative of their sectors over time.

Have a happy holiday! Dr. Kris will be on vacation until July 13th and Professor Pat has volunteered to take on blogging duty in my absence. He has some really interesting topics that he’ll be presenting. No channel changing!

Wednesday, July 1st, 2009

*Blue Plate Specials* – July 1

Breaking Out on lower volume: BLKB, ESE, FAF, JCI, KB, LIOX, MOVE, MTD, ORCL, PEP, SCI, TEN, XL
Breaking Down: FRPT, GXDX, LEAP, MYGN, NAV
New Highs on lower volume: APKT, ATSG, DLM, HMSY, LAD, MIN, OMN, PBY, RDY, SCLN, SGP
New Lows: VXZ (a volatility ETN)
Low-priced leaders: APKT, ATSI, CRAY, DLM, OMN
Commodities: Livestock (COW) breaking out; Nickel (JJN) at short-term high
Sector watch: Utilities (UTH) breaking out; many on verge of breaking out
Profit taking?: CKSW, DTG
Strangle opportunity?: JPM
M&A: MCRO one-ups mystery bidder for BORL, increasing stake to $1.50 per share
Darlings of the Day: CRAY, MENT, SNX, TEVA, UIS
Market Notes: VIX continues decline-bullish for the market; Dow Transports close to breaking above 200dma