Gold is hitting new highs and many investors may be looking to add the metal to their portfolio. ETFs make gold easy to buy, but investors should take a different approach with gold than with stocks when considering where it fits in their portfolio.
In the past five years, Apple is up more than 600 per cent, well ahead of SPDR Gold Shares' nearly 200 per cent run. The past five years have seen a string of successful new products from Apple, while inflation and financial crisis have lifted gold.
Apple's success shows that at the end of the day, creative minds are a better bet than the yellow metal. For many blue chip companies, however, the creativity and innovation hasn't been nearly enough. In the past five years, GLD has trounced major blue chip companies such as Wal-Mart , Exxon Mobile and Procter & Gamble . Those companies have performed well relative to other stocks as measured by the S&P 500 Index, which was up an annualized 2.6 per cent over the past five years. With reinvested dividends, investors holding these shares have done well and their returns over the past five years are solid, but many investors are looking for more.
If they turned to Google , which is up more than 100 per cent in the past five years, they'd find that it too has trailed gold by a healthy margin. Google hasn't seen its share price advance nearly as much as Apple's gain, but is most certainly a creative, innovative and financially successful company. Still, it was unable to beat the allure of the "barbarous relic."
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However, it really doesn't make sense to compare individual stocks to gold (unless they're mining it). A more appropriate measure is to compare all stocks to gold. Instead of deciding between Apple and gold, investors should decide between stocks and gold, with stock selection a separate decision.
In 2000, at the height of the technology bubble, the S&P 500 Index traded at a ratio of 5 to 1 versus one ounce of gold. At the other extreme, in 1980, the S&P 500 Index traded for one-sixth of the price of gold. The swings are the result of changes in investor sentiment. In 2000, investors believed in the "new economy," that the business cycle had been tamed and the Internet would unleash rising profit margins for years to come. In 1980, they held the opposite view, wondering if the U.S. would ever exit a stagflation that had plagued the country for years.
The difference between these two periods is stark. In one period, investors are very optimistic and they are focused on what businesses are doing. Investors might compare Coca-Cola and Pepsi based on management, strategy, new products, valuation, etc. In the other period, the difference between Coca-Cola and Pepsi doesn't appear as great. Investors are more focused on geo-political concerns and want to know what the government will do, rather than what a company will do.
It's a case of the two types of risk taking prominence: market risk and firm-specific risk. When investors are willing to take market risk, firm-specific risk becomes much more important. But when investors are unwilling to take market risk, firm-specific risk fades into the background. Investors can reduce firm-specific stock risk by holding many stocks from different industries. To diversify the risk of stocks themselves, they need to hold something besides stocks.
When risk gets high enough, that something has often been gold. This chart shows the ratio between SPDR S&P 500 Index and SPDR Gold Shares over the past three years.
The stock market rally looks less impressive on this chart, as stocks have failed to gain ground on gold since August 2009.
Gold really started outperforming stocks in the past couple of weeks. The eyes of the world were focused on Greece and European governments, wondering how they'll solve an escalating debt crisis. In this situation, investors sold stocks almost indiscriminately and sought the safety of gold. Bonds and cash did well too, but not as well as gold, because investors wonder if the solution to debt problems will involve default or inflation.
The lesson for investors here is that gold is a hedge against risks that hurt stocks (and bonds too), rather than an alternative to stocks. Therefore, don't base a decision to invest in gold on whether or not it did better or worse than particular stocks. Instead, think of it in relation to your total stock risk.
When risks stemming from political decisions, including inflation, are high, adding some gold to a portfolio will hedge this risk. It doesn't make sense to abandon stocks, however. While the ratio between the S&P 500 and gold is a useful indicator, the S&P 500 Index quoted each day does not include reinvested dividends. The S&P 500 Index closed at 1155 on Tuesday, but the S&P 500 Total Return Index, which includes dividends, closed at 1917. The impact of dividends over time is a significant portion of returns, which is why investors should also be invested in solid dividend paying firms such as those found in ETFs like the iShares Dow Jones Select Dividend Index .
Current market conditions are a reason to be prudent, not to panic. During last week's "flash crash," the price of gold and bonds went up, not down. Beyond just protecting your portfolio, diversification can also protect your emotions from harming your investment decisions.
At the time of publication, Dion Money Management owned IAU and DVY.
Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. He is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets. He also is publisher of the Fidelity Independent Adviser family of newsletters, which provides his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds.
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