A useful diversifier

Effective diversification relies on low correlation between constituents in a portfolio. Typically, in a traditional portfolio set-up, investors would hold a mix of equities and bonds. This is premised on the view that bonds will offset declines in equities during periods of market stress, seeing that it is the preferred low risk choice during market turmoil. This is expected to keep the volatility of portfolios low and stabilize returns.

Diversification can be improved by including instruments that are less correlated with existing assets in a portfolio. In this regard, some exposure to precious metals might be a good choice.

Precious metals refer to gold, silver, palladium and platinum. As an asset class, precious metals have exhibited low correlation with global equities and bonds, making it a useful portfolio diversifier for traditional equity-bond portfolios.

Not the typical commodity

One might be tempted to regard precious metals as general commodities that are vulnerable to the whims of global demand and supply. But that would be equivalent to me telling you that the sky is blue. Of course, these metals obey the law of supply and demand.

Being industrial metals, silver, platinum and palladium, are key raw materials in the production of certain goods. For instance, silver is largely used in the manufacturing of solar cells, while platinum is used in automotive catalysts. Palladium is used for a variety of products ranging from electronics to other industrial applications. The final demand for these products typically affects the trading price of the underlying raw materials.

But precious metals also serve another purpose – they are a good store of value, primarily because they are rare, hence, precious.

Look no further than gold. Investors typically rush for the yellow metal during market panics or when fear of inflation rears its ugly head. It is a safe haven asset.

Gold has been one of the better performing asset classes over the past couple of years as investors rush into its warm embrace during periods of volatility. Meanwhile, central bank buying has also boosted gold prices. Typically, gold forms part of a central bank’s reserves and monetary authorities have loaded up the bullion as a way to diversify from the US Dollar.

In terms of long-term total returns, precious metals have outperformed general commodities. These metals are precious after all.

Insurance against unexpected inflation

Precious metals might also be good insurance against inflation. When the value of cash decreases (i.e. you are not able to afford the same basket of goods with the same nominal amount of cash) due to inflation, having access to a stable store of value like gold is beneficial. The massive amount of liquidity pumped into the economy following the pandemic has put the US dollar and major currencies under pressure. Simply put, gold serves to be a stable source of value even as major currencies may be hit by depreciation when monetary supply increases.

This is especially pertinent in the current environment where central banks and governments have essentially spent a great deal of money to address the coronavirus problem. The long-term repercussions of unlimited quantitative easing and increasing government debts are still being vigorously debated in the profession today.

In any case, instead of choosing a side in this debate, perhaps it is best to keep some insurance against the unforeseen.

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