Gold and Low-Volatility Stocks as Diversifiers

Gold has long been regarded as a valuable diversification tool in investment portfolios due to its unique characteristics. As an asset class, gold has historically exhibited a low correlation with traditional financial assets such as stocks and bonds. This means that gold often moves independently of other investments, especially during times of market stress or economic uncertainty. By incorporating gold into a portfolio, investors can potentially reduce their overall risk and enhance the stability of returns.

One of the primary reasons gold is considered a diversifier is its perceived safe-haven status. During periods of economic downturns, geopolitical tensions, or currency fluctuations, investors tend to flock to gold as a store of value and a hedge against inflation. Gold has a long-standing reputation as a tangible and finite asset that can retain its purchasing power over time. As such, its inclusion in a diversified portfolio can help mitigate losses during turbulent market conditions and provide a potential source of stability and resilience.

Reference [1] revisited the role of gold as a diversifier in a traditional stock-bond portfolio. It concluded,

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The golden rule of investing is to avoid capital losses. To this end, some conservative investors hold a part of their wealth in gold. Indeed, our empirical study corroborates that a portfolio’s loss probability, its expected loss and downside volatility can be brought down with modest allocations to gold. However, hedging downside risk via gold investing comes at the cost of lower return.

In short, the author reaffirmed the role of gold as a good diversifier. However, they also pointed out the weakness of using gold in an investment portfolio: it lowers the returns.

The article then proposed to add low-volatility stocks to the portfolio in order to reduce the risks without sacrifying the returns,

Conversely, including low-volatility stocks in the multi-asset portfolio increases its defensiveness considerably, without giving up returns. Notably, the effectiveness of the resulting defensive multi-asset portfolio increases with the investment horizon. While we have intentionally kept the empirical setup concise, it could readily be extended to consider additional asset classes and factors. Notwithstanding, perfect safe havens are difficult to find, but a mix of defensive equities, bonds and a small allocation to gold can help to reduce capital losses.

Let us know what you think in the comments below or in the discussion forum.

References

[1] van Vliet, Pim and Lohre, Harald, The Golden Rule of Investing, 2023. https://ssrn.com/abstract=4404688