The financial markets have never been as complex and troubled as they are today, creating a major challenge to prudent investing. At the same time, investors have never had such effective tools to guide them through the process, chief among them diversification.
Diversification Definition: the practice of including different financial investment instruments in a portfolio to reduce risk and maximize returns.
What is now called Modern Portfolio Theory was introduced in the fifties by Harry Markowitz. Rooted in the concept of minimizing risk over an investor’s portfolio by the use of diversification, MPT has transformed the entire field of investment. In fact, it has proven so significant it earned Markowitz the Nobel Prize in Economic Sciences in 1990.
One of the main tenets of Markowitz’s work was that different asset classes react differently to market conditions. Moreover, those assets would often work in opposition to each other, such as precious metals and interest-bearing bonds. Markowitz asserts that the opposing movement of asset classes can buffer diversified portfolios 1 from the ravages of market cycles.
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While the mathematics behind the work that earned Markowitz the Nobel Prize is quite esoteric, the investment community now universally relies on the four tenets of MPT:
- Valuing various assets based on their historic and expected rates of return and risk
- Allocating assets within a portfolio based on these classifications
- Optimizing a portfolio based on accepted risk and return profiles
- Measuring portfolio performance relative to the market and industry-related categories
Diversification has proven to be effective in providing an “optimized portfolio” that delivers the highest possible returns at a controlled level of risk based on investor profiles and expectations. Industry professionals speak of an “efficient frontier” that places limits on assets. This standard evaluates investment classes that provide too little return for the relative risk or, from a different perspective, too much risk for the expected return.
Gold’s Role in Diversification
For some time after the concept of diversification was introduced, many analysts showed a bias against including gold and precious metals in the optimized portfolio. Central to the arguments of those who eschewed gold was the fact that it pays no dividends or interest.
However, time has shown that point to be something of a red herring, as gold continues to produce significant returns over the long term and demonstrate its portfolio value. 2 In reality, this should not be surprising, as gold has proven for millennia to be a preferred way to store and transfer value. As both a safe haven investment and a hedge against inflation, gold provides both tangible and intangible returns at a low-end risk.
When Paper Currency Fails
It is important to note an additional critical factor. The world economic system has been engaged in a paper currency experiment for more than fifty years. During that time, governments have engaged in massive, unsustainable deficit spending and a global debt crisis.
When that experiment fails, as many believe will happen in the near future, market assumptions about the risk of paper-currency-based investments will prove to be incorrect. The consequent financial collapse will again validate the wisdom of having at least a percentage (10 to 20 percent) of every portfolio invested in gold and silver. 3
With gold continuing to provide a return while providing security and peace of mind, it is easy to understand why investments in gold have reached historic highs.