Has the Gold Rush Passed You By? Examining Diversification and Risk Management

When an investment performs at or above expectations, the crucial question becomes: what's next? This is the challenge facing gold investors today, especially after the precious metal has marked over 30 new all-time closing highs this year. "Don't be scared by the recent large move up," says Chris Mancini, co-portfolio manager of the Gabelli Gold Fund at Gabelli Funds. "We don't think you've 'missed it,' and it still makes sense to own gold."

Why Gold Remains Attractive

Mancini points to the freezing of Russian foreign exchange reserves after the 2022 Ukrainian conflict, prompting many countries to reduce their reliance on the US dollar as the global reserve currency. Further supporting gold's appeal are the elevated US debt-to-GDP ratio since the pandemic, projected deficit increases following the Trump administration's 'Big and Beautiful Act,' and concerns about the Federal Reserve's independence. Gold has not only reached record highs in nominal prices but has also surpassed its inflation-adjusted historical peak.

Gold as an 'Insurance Policy'

"Even though gold prices are at all-time highs, the investment thesis hasn't changed: Every portfolio should have some gold," says Louis LaValle, co-founder and CEO of Frontier Investments. He adds, "Gold is like an 'insurance policy'—you don't cancel it when premiums go up, nor do you double down when you need to make a claim. You simply reasonably adjust the allocation, hold it, and let it do its job."

'Reasonable' Gold Allocation

LaValle believes funds are shifting toward bonds, money markets, and precious metals because the era of 20%-30% returns in the US stock market cannot last forever. He describes the current financial market environment as "bubbly"—though this doesn't mean the market will crash tomorrow, it does mean the margin for error is very slim, so "discipline is critical now."

Financial Advisor Recommendations

Over the years, financial advisors have typically recommended investors allocate 5%-10% of their portfolios to gold. This advice appears to remain valid, despite the significant rise in gold prices. Mancini from Gabelli Funds believes that, given the current macroeconomic backdrop—de-dollarization trends, rising US debt, doubts about the Fed's independence, and risks facing the dollar—it still makes sense for investors to allocate 5%-10% of their funds to gold-related investments (including gold stocks).

UBS's Perspective

Jason Draho, head of asset allocation at UBS Global Wealth Management Americas, states that UBS currently also advises allocating to gold, but at a rate of less than 5%. Draho attributes allocating a portion of the investment portfolio to gold to growth and inflation risks and the de-dollarization trend, all of which support considering gold as an "effective portfolio diversifier."

Challenges and Risks

However, Draho warns that "gold generates no yield or interest, so holding it involves an opportunity cost." He explains that these funds could have been "allocated to high-quality bonds with a yield of over 5%." He also points out that "gold is highly volatile in the long term." He says that gold's volatility could reappear, meaning that "there is a risk of a significant correction." He emphasizes that the "reasonable absolute allocation ratio for gold depends on the investor themselves, their overall risk tolerance, and long-term target allocation ratios."

Gold's Changing Role

For investors, gold's strong performance may mean a shift in its traditional safe-haven role, a shift that could push gold prices higher. Peter Grant, vice president of Zaner Metals and senior metals strategist, says, "History has proven that gold is an excellent risk diversification tool in the investment portfolio, even a small allocation can reduce overall volatility and improve returns. Gold reaching record highs doesn't change that."

Gold's Appeal Goes Beyond Inflation Hedging

Gold's appeal is not limited to hedging against inflation and economic uncertainty. Ryan McIntyre, senior portfolio manager at Sprott Asset Management, says, "Investors' confidence in gold is gradually increasing. Gold's role has surpassed that of a traditional hedge. For institutional investors and sovereign nations, it is becoming a strategic reserve asset."

Increased Demand from Central Banks

Data from the World Gold Council shows that investor interest in gold has increased, with gold-backed exchange-traded funds (ETFs) globally recording net inflows for the third consecutive month in August. Gold-backed ETFs globally attracted $5.5 billion in August, with North American funds contributing $4.1 billion. Net inflows since the start of the year have totaled $47 billion, the second-highest on record after the peak in 2020. McIntyre points out that central banks have been buying gold on a historical scale over the past few years "to diversify their foreign exchange reserves and hedge against currency and geopolitical risks." Data from the World Gold Council shows that central banks have purchased more than 1,000 tons of gold annually over the past three years, while the average annual purchase during the previous ten years was only between 400 and 500 tons.

Conclusion

In conclusion, gold remains an attractive investment opportunity under current economic and geopolitical conditions. However, investors should consider the risks and challenges associated with investing in gold, and determine an appropriate allocation based on their risk tolerance and long-term investment goals.