Season Investments


The Barbarous Relic

Posted on January 28, 2014

“In truth, the gold standard is already a barbarous relic.” – John Meynard Keynes

Last year was not a pretty year for gold. The spot price of fell almost 28% making it the second worst year since Nixon took the US completely off the gold standard in 1971. The sell-off was almost entirely due to a radical drop in the investment demand for gold in the developed world, specifically demand by investors who hold claims on gold through derivatives or exchange-traded funds as opposed to investors who hold physical gold. On the flip side of the coin, physical demand for gold, specifically demand in emerging markets such as China, as well as jewelry demand increased dramatically in response to the sell-off in the spot price. But none of that changes the fact that gold had its second worst year on record in the last four decades and investors who were long the shiny metal felt the pain. Compounding the pain was the fact that the stock market, and in particular the US stock market, was up big in the same year.


This has led many to question the merits of investing in gold. The “barbarous relic” bandwagon has become quite full as market commentators have been tripping over each other with child-like glee to pronounce gold’s demise. This type of sentiment swing is part of investing and can be very painful when one finds themselves on the wrong side of the trade. Trading can be extremely lucrative and there are some that make a king’s ransom doing it, but for rest of us without an edge in the zero sum game of trading, our time is much better spent on investing. The most successful investors are those with high conviction in a disciplined approach which focuses on long-term success and risk management. We believe that the investment philosophy that best encapsulates this recipe is one based on the endowment model, which invests in assets beyond stocks and bonds to include other private and public holdings such as hard assets (real estate, commodities, gold, etc.), currencies, and absolute return strategies. The idea behind the endowment model is that true portfolio diversification is achieved by spreading money across different buckets which are driven by different macro influences. The endowment model carries with it an air of humility as its basic premise is that no one knows the future, so the best portfolio is one that spreads its bets across as many different investment types as possible. In this way, there is always the potential to do well in any investment environment, rather than betting the farm one or a couple potential outcomes.

When one looks at the future through this lens, it is much easier to take a long-term view to investing versus the knee-jerk, “what have you done for me lately” headlines that bombard us every day. So what does this mean for gold and its roll in a diversified portfolio? It means that we should not let one year’s performance change our opinion on its efficacy as a portfolio holding, but instead we should take a longer-term and fundamental view when addressing this question. Fundamentally, the arguments for holding gold are fairly easy to understand. In its simplest form, gold is a put option on the free lunch belief in the omnipotence of the central banking system. I’m sure everyone has a father or a grandfather who has told them that there is “no such thing as a free lunch” and we for one believe this also applies to central bankers playing god with the economy and people’s faith in fiat currencies no longer backed by a barbarous relic like gold.

Be that as it may, gold still sucked wind in a year where central banks printed more money than in any other year prior. So we decided to take a longer look back at the history of gold and that of the S&P 500, which we will use as a proxy for “stocks” even though we firmly believe that an allocation to stocks in a portfolio should be global versus simply domestic. The chart below shows the total return of gold, the S&P 500*, and an arbitrary 50/50 blend** of the two from 1972 through 2013.


A cursory glance at the chart above shows the diversification benefit of holding both stocks and gold as there are long stretches of time where they move independently of each other. Even though the 100% stock portfolio performed the best over the given time period thanks in part to the strong performance of the S&P 500 over the past couple years, the blended portfolio came in a close second with much less volatility and risk. Smoothing out returns by reducing volatility is not only good for a portfolio from an absolute return perspective (see our video on the Economics of Loss), but it also helps investors from being their own worst enemy and making knee jerk decisions at the most inopportune time. The final takeaway from the chart above is that the 50/50 portfolio has moved sideways to down over the past year as gold’s drop has offset the S&P’s strong performance, which is a real, short-term price one can pay for holding a portfolio of non-correlated assets.

Taking this example one step further, we wanted to see what the “optimal” mix of stocks and gold would have been over the given time period. The chart below plots the annual volatility and return of portfolios ranging from 100% stocks to 100% gold**. The optimal portfolio is one that maximizes returns for every incremental unit of risk. In this example, the optimal portfolio happens to be 70% stocks and 30% gold.


The embedded table in the chart above shows that it was actually more profitable and less risky to hold the 70/30 mix than it was to hold just stocks or just gold. The whole being greater than the sum of the parts is the fundamental backbone of diversification. The synergy of diversification is most pronounced when assets show little to no correlation to one another, such as the case with gold and stocks. But as we saw last year, uncorrelated return streams can also cause periods of relative pain. Mind you, this pain is based on opportunity cost against an arbitrary all US stock benchmark.

At Season Investments, we don’t pretend to deliver stock market returns (there will be future periods where this will be a good thing), nor do we benchmark ourselves off this single asset class. We are firm believers that a portfolio predicated on real diversification is the best way to invest. Are we disappointed that our portfolios lagged in 2013? Of course! But does it mean that short-term disappointment should dictate our long-term investment discipline? Absolutely not. This is why we are staying the course with our Diversification 2.0 portfolio construction which includes, among many other things, a dedicated allocation to gold.

* S&P 500 Total Return index from its inception in 1988 to present. S&P 500 price return index with a monthly gross up for 1/12th of the historical annual dividend yield as provided by NYU for 1972 – 1987.
** Assumes monthly rebalancing.

elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.

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