Dow Peaking? The Quick Guide to Diversifying Your Stock Profits
-- Published: Tuesday, 21 November 2017 | Print | Disqus
By Jeff Clark
It’s been a heck of a run.
The S&P has nearly quadrupled since its 2009 low. It currently ranks as the second-longest bull market in the last 140 years (top green bar).
Just as important as recognizing the frothiness of the current market is the fact that the stock market has always fluctuated between bull and bear markets. No bull market lasts forever—that will include this one.
Regardless of your personal outlook for the stock market, capturing some of your profits is only prudent given how long this market has been chugging higher. It’s also a way to build wealth, since you now have some money to build a position in other investments.
But what? Buying different stocks than what you own would expose you to the same frothy market. The current real estate market wouldn’t allow us to buy low. And loading up on bonds doesn’t really help since they pay next to nothing despite the bump in rates.
There’s actually a straightforward way to achieve true diversification…
The Secret to Effective Diversification
Many investors think they’re diversified because they own domestic stocks and foreign stocks. Or government bonds and corporate bonds. But that’s not real diversification because they’re essentially the same asset class and tend to rise and fall together.
The key to proper portfolio diversification is this:
Buy non-correlated assets
In other words, you want an asset class that tends to rise when others fall. It doesn’t do much good if all your investments rise and fall together.
So what assets might have a low correlation to stocks? In other words, what could you buy that won’t fall victim to the next bear market or recession?
The following 40-year study shows the correlation of gold to other common asset classes. The zero line means gold does the opposite of that investment half of the time. Figures below zero means gold moves in the opposite direction of that investment more often than with it (and vice versa if above zero).
You can see that historically, gold moves opposite of the US stock market more often than with it. They are thus considered negatively correlated assets.
This makes sense when you think about it… stocks benefit from economic growth and stability, while gold responds to economic distress and crisis. If the stock market falls, fear is usually high, and investors typically seek out the safe haven of gold. If stocks are rocking and rolling, the perceived need for gold from investors is low.
History bears this out. Here’s how the gold price has responded during the S&P 500’s biggest market selloffs since the 1970s.
Dates of S&P 500's Biggest Declines
Sep 21, 1976 - Mar 6, 1978
Nov 28, 1980 - Aug 12, 1982
Aug 25, 1987 - Dec 4, 1987
Jul 16, 1990 - Oct 11, 1990
Jul 17, 1998 - Aug 31, 1998
Mar 27, 2000 - Oct 9, 2002
Oct 9, 2007 - Mar 9, 2009
May 10, 2011 - Oct 3, 2011
On average, when the stock market crashes, gold has historically risen more often than declined. (And the fine print on the 46% decline is that it occurred just after gold’s biggest bull market in modern history.)
This is practical information for investors:
If you want an asset that will rise when stocks and most other assets fall, gold is likely to do that more often than not.
It doesn’t mean gold will automatically rise with every downtick in the stock market. In the biggest crashes, though, history says gold is more likely to be sought as a safe haven.
It is gold’s lack of correlation to all other assets that gives your portfolio protection against significant market drawdowns. Indeed, no alternative asset can match gold’s non-correlating, portfolio-protection power.
Now is an Ideal Time to Diversify into Gold
There’s another benefit to buying some gold now. Relative to stocks, gold is undervalued.
Gold is a bargain compared to the lofty value of the S&P 500.
Further, as I write, gold is priced roughly one-third below its 2011 high.
Silver offers an even deeper value, being two-thirds below its prior high.
In other words, precious metals currently offer a very attractive one-two punch:
Gold is not only uncorrelated with the stock market, its current price is undervalued.
That’s why now is an ideal time to diversify some of your stock profits into gold.
So, what kind of gold do you buy?
The Advantages of Physical Gold
There are a lot of ways to buy gold—ETFs, futures and options, and even fractional and pool accounts. But buying a paper product defeats one of the primary advantages gold carries:
Physical gold—coins and bars—offer the last line of defense in an emergency.
Any paper form of gold is vulnerable to fraud, abuse, and mismanagement. The few ETFs that offer delivery are expensive and subject to delays and fulfillment issues. Even the liquidity—your ability to get out when you need to—can be compromised. A gold Eagle coin in your hand is subject to none of these risks.
Check out all the advantages you gain by owning physical gold, none of which you’d have with a paper product. Physical gold is…
A tangible asset. There’s nothing quite like the heft of a gold coin or bar in your hand. Most investments don’t come in tangible form, and physical gold can’t be destroyed by fire, water, or even time. And unlike other commodities, gold coins don’t need feeding, fertilizer, or maintenance.
Free of counterparty risk. Physical gold requires no paper contract to be made whole. Gold is the only financial asset that is not simultaneously some other entity’s liability. It doesn't require the backing of any bank or government.
Highly liquid. Physical gold can be sold virtually anywhere in the world. There are gold dealers in just about every major city on the planet. And in a crisis, gold will be in high demand. Other collectibles, like artwork, take longer to sell, have a smaller customer base, and will likely entail a big commission.
Value dense. You can hold $50,000 in gold coins in the palm of your hand. Gold coins take up such little space that you can store more value of them in a safe deposit box than stacks of dollar bills.
Private and confidential. How many assets can you say that about in today’s world? You must pay taxes on any gain, of course, but if you want a little privacy or confidentiality, just buy some gold coins.
Portable. You can take gold coins with you wherever you go in the world.
A store of value. The gold price fluctuates, of course but its value is timeless. Consider that gold retains its purchasing power over long periods of time, while the US dollar, for example, has lost 98% of its purchasing power since the creation of the Federal Reserve in 1913. And since gold will outlast you, it is an ideal asset to pass on to your heirs.
By the way, it’s a faulty argument that gold doesn’t produce income. That’s not gold’s role. Its function is as money and a store of value, similar to a currency. That’s also why it shouldn’t be viewed as a commodity; it doesn’t get used up, like oil or corn. Gold’s first and foremost use is as money.
Can’t be hacked or erased. It’s probably not a good idea to keep all your wealth in digital form today, where malware and cybercriminals live. That’s easy to do if you own some gold.
Requires no specialized knowledge. If you don’t know how to spot a real diamond, aren’t familiar with the paintings of Van Gogh, or don’t collect comic books, just buy some gold bullion. No special skills or education needed.
Comes with low maintenance and carrying costs. Even if you pay for storage, compare that to the costs and taxes and headaches of, say, real estate. You don’t even need a stock broker to buy and sell gold.
Buy only physical gold products, whole coins and bars.
The Best Form of Gold to Buy
An investment in gold starts with products that give you direct exposure to the gold price. This excludes rare coins or off-brand bars, as they depend on different variables and would increase your risk.
The best way to determine what to buy is to start with the end in mind: what will be easiest to sell?
As an investor, you want to buy something that won’t just rise in value, but that will also be easy to sell when the time comes. You want to avoid a product that could experience a delay when it’s sold, or cost you more than you expected, or won’t have a lot of buyers. You want an asset that comes with high liquidity—in other words, is easily recognizable, can always be sold for the price of gold, and will have plenty of customers.
There’s one class of gold that meets these criteria:
Sovereign (government) coins are the most widely known around the world and thus will be the easiest to sell. Even if you never sell them but pass them on to your heirs, they will need something that’s easy to sell.
So the “golden” rule when buying gold coins is this: buy the most common or popular items, so that you have high liquidity when the time comes to sell.
Whatever you do, the time is now to diversify into gold. All markets cycle, and a down-cycle for stocks and an upcycle for precious metals is on the doorstep. Take some of your profits and buy some undervalued gold.
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