Diversification is the first rule investors learn. Spread your investment across a greater number of assets to avoid overexposure to risk in one area. The concept is simple and intuitive. It is also becoming more difficult to follow.
Assets become more correlated as the economy becomes more globalized. This increasing globalization is more apparent than ever as sanctions against Russia take hold. In response, European countries are struggling to find energy alternatives. Simultaneously, countries are bracing themselves for higher food prices as grain from Ukraine becomes scarce.
This setting presents two challenges: First, a lack of resources from any one country is often felt globally. Second, as more countries become reliant on one another more investments tend to move in correlation with one another. This characteristic of today’s economy makes it more difficult for investors to diversify.
The rising correlation of assets is evident in research which points to “a rise of cross-asset correlation between select asset classes.” The research shows “an average correlation increase of 33% between the test periods 1990-2000 and 2006-2016.” This elevated correlation is a problem because, “a significant market event or correction can be compounded by a period of highly correlated assets across integrated financial markets.”
A “significant market event” is becoming more common in the unpredictable environment of today. Since the publication of the research the globe has seen a major pandemic and a war.
As correlation rises investors are struggling to safeguard their portfolio. More investments are beginning to look the same. What happens over here is more likely to happen over there as more businesses become reliant on each other. This conundrum has prompted investors to find diversification by taking a new look at asset classes like gold. This solution, however, leads to another question: What is the right amount of a portfolio to allocate to gold?
Research from State Street in cooperation with the World Gold Council determined that “gold has had low or negative correlation with major equity indices since 2000.” Additionally, their data shows that gold also has a low, or negative correlation to major bond indices.
Their findings also reveal that during nine of the last eleven “black swan” events gold has delivered a positive return. Examples of such events include the 2008 market crash, “Black Monday,” and the flash crash of 2010.
The bottom line is clear: As correlation rises it is becoming more difficult to diversify. Gold offers an important alternative to equities because it is far less reliant on supply chains, interest rate movements, and business operations in other countries.
State Street and the World Gold Council suggest that allocating anywhere from 2% to 10% of a portfolio to gold can improve the Sharpe ratio of the portfolio. The Sharpe ratio is a measurement that enables investors to gauge the risk/return balance of a given investment. Therefore, by holding more gold, investors can improve the risk profile of their total investment strategy.
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