Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:38]

Thank you, Mary, and welcome to episode 12 of Risk Parity Radio. In today's episode, we're going to talk about gold as an investment, which seems to inspire the most love and the most hate for any asset class, and lots of storytelling. Gold has been in the news the past couple months because the price has been going up, and some well-known investors have gotten involved. Warren Buffett has bought shares in a gold mining company, and Ray Dalio has increased the gold holdings at Bridgewater's flagship hedge fund to 20%. So people are getting excited about gold as they seem to get excited every decade or so. So to frame that discussion and to avoid attractive narratives and cognitive biases, we are going to use a process You should always use a process when considering any kind of investment. And the process we will be using to analyze gold is the same one we discussed in episode 9, which is framed around David Stein's 10 questions. 10 questions to master successful investing. Now if you haven't listened to that episode, you might want to pause here and go back to it or listen to it afterwards. We will put the questions in the show notes. For your reference. But before we do that, I'd like to stop and give you a small rant about misinformation or miswisdom that I have heard on podcasts in the past month about investing. I don't know if I'll do this every month, but maybe we'll make it a regular feature if it feels right. Now, I'm not going to name any names, but this misinformation comes from trusted sources that I would ordinarily find reliable. So I have to believe that it is part of a conventional miswisdom and what I'll call a foolish consistency of the financial services industry, which still seems to be stuck in the 1980s and 1990s as far as advising individuals is concerned, other than telling them to use index funds now instead of managed mutual funds. And there is a cognitive bias towards repeating information without questioning it. or to fall prey to the fallacy of the appeal to authority. If somebody famous or whom I like or respect said it, it must be true. But that's a fallacy and we need to examine the information on its own. Okay, the first bit of Miss Wisdom I heard last month. I heard somebody say that you should hold small cap value stocks because they are negatively correlated with the rest of the stocks in the stock market. Let me repeat that. I heard somebody say that you should hold small cap value stocks because they are negatively correlated with the rest of the stocks in the stock market. What about this statement? This is a false statement. It's not even close to being a true statement. All we have to do is go and look up the correlations. which we can do quite easily ourselves over at portfoliovisualizer.com so I did that to compare small cap value with both the total stock market and its opposite large cap growth to see if the statement was true or false. And I'll link to that analysis in the show notes. But what did I find? Well, small cap value is positively correlated, positively correlated. with both the stock market, the total stock market, and with large-cap growth stocks. And it's not just positively correlated, it's very highly positively correlated. Small-cap value is 86% positively correlated with the total stock market. Small-cap value is 77% positively correlated with large-cap growth stocks. So what does this mean? It means that the idea that small-cap value can provide significant diversification to a portfolio that is otherwise all stocks, all other stocks, it's just false. It's a false idea, it's a false statement, and you shouldn't believe it. This is a foolish conventional miswisdom that goes with a larger foolish conventional miswisdom. And what it violates is the macro allocation principle from Jack Bogle that we discussed in episode seven. Because the truth of the matter is that almost all stock funds are going to be highly positively correlated. If you want a diversified portfolio to hold in retirement, to hold for drawdowns, you need to look beyond stock funds. Small cap value is not going to save you. International funds are not going to save you. They are not significantly diversified from the stock market. And we see that happening this day, this is Thursday, and on this Thursday, the stock market is down between 3 and 5%, depending on what part of it you're looking at. The Dow is down 1,000 points, and all the stocks are down. All the stocks are down. If you want to have diversification, you need to own things like treasury bonds. Treasury bonds are up today. You need to own things like gold. Gold is flat today. So if you look at the activity of the sample risk parity portfolios today, you see that the four conservative ones that we use and recommend are down only between 1 and 2%. They are not down 3, 4, 5%. Only the experimental portfolios are down along those lines, but even they are down less than the total stock market or the total NASDAQ. Second bit of missed wisdom I heard last month. I heard a whole show on this from a famous guru who was talking about the problems with traditional 60-40 stock bond retirement portfolios and the 4% rule of thumb these days. And he was saying that it might not work as well today as it has in the past due primarily to the low interest rates available on most bonds. And then he said that there were only three solutions that he had come up with, only three in the entire world. One was to hold more cash, a second one was to buy annuities, which his firm advises on, and a third one was to use reverse mortgages. And that was all that was on his menu, the entire menu. That was all you were permitted to do to deal with your 60/40 problem. Now this information And these statements are an example of the cognitive bias that Daniel Kahneman called WYSIATI. That's an acronym and it's spelled W-Y-S-I-A-T-I. And it stands for what you see is all there is. What you see is all there is. And this is an endemic problem in the financial services industry because financial advisors generally work with a set menus of options that they present to clients. These menus come from whomever they work for and whomever they work with. They are like the waiters in the restaurant. They don't even set the menus usually. They just present them. And usually the items on those menus pay them commissions and other fees. Those menu items are good for the advisor. Now, some of those menus are broader than others, but almost all of them are limited and stay within certain boxes. What we need to know as financial consumers, as do-it-yourself investors, are that what they show you, what they present you, what you see is not all that there is. There are other restaurants with different menus. And if we are cooking for ourselves, there are many other good choices that are better for financial health in the long run. You are not constrained by your financial advisor's limited knowledge and conflicts of interest. To paraphrase Fight Club, you, portfolio is not your advisor's meal ticket. Your portfolio does not have to wear The advisors khakis because they have a famous brand name on them. In this case, there are other solutions to the 60/40 problem other than cash annuities and reverse mortgages. That assertion was false and it was conflicted, by the way, because the advisor shop does a brisk business recommending annuities. One of those other solutions is risk parity style portfolios. what we discussed here, and it's a much better one than the limited options on those limited menus of choices. Well, I think that's enough ranting for one month. Let's get back to the main course, or the main aisle in the grocery store since we're shopping for ourselves. Let's get on to our 10 questions and apply them to considering gold as an investment. First question：What is it? What is gold? Well, to be technically precise, gold is a chemical element with the symbol Au and atomic number 79, making it one of the higher atomic number elements that occur naturally. In a pure form, it is bright, slightly reddish-yellow, dense, soft, malleable, and ductile. Chemically, gold is a transition metal. Now that's a very technical definition and not very financial, because obviously not all rare elements are used like gold has been. So what else is gold? As Yuval Harari tells us in the book Sapiens, what is just as real to human beings is not just a thing, but also the ideas about that thing. What we have believed and told ourselves about a thing. maybe just as real as the thing itself. And from ancient times, gold has been prized as a rare possession, and it's been used to make jewelry and ceremonial objects. Golden calf, anyone? And from time to time, gold has been used as money, either directly in its physical form, or tied to some paper, like a gold certificate. Central banks of most countries still hold gold as a backstop or measure of confidence in their monetary systems, even if they don't officially use gold to back their money anymore. That's what the US government does. Now in today's financial markets, gold behaves as an alternative currency, if you look at it, since 1971 since it's not tied to the dollar anymore. And you do need to consider gold before and after that date when it began to float. in terms of dollars. Now gold is not something you can use very well to buy anything directly, but it is freely convertible into just about any other currency in the world. So it can be used as a store of value. Second question from David Stein：Is gold an investment, a speculation, or a gamble? Well, we know that gold does not pay an income like a bond. And it's not profitable like a business. So technically, according to the Stein definitions, it's not an investment. Its value is derived from the fact that we know other people value it, and there is a public market price for it. And on that scale, we would characterize gold as a speculation. It's not a gamble because it does retain its value and increases in value over time. So it's definitely a speculation, not an investment or a gamble. Third question, what is the upside? Well, the upside of gold is that it seems to at least keep pace with inflation over long periods of time and sometimes performs better, or at least as well, as the stock market or any other investment. So running a small backtest over at Portfolio Visualizer again, We can see that since 2004, which we will link to in the show notes, gold has actually been slightly outperforming the stock market with similar volatility. To be specific, gold has a compounded annual growth rate since 2004 of 9.63% compared to the compounded annual growth rate of the total stock market of 9.35%. They have similar standard deviations, similar Sharpe ratios, and the only thing that's really different about them is the lack of correlation, the complete lack of correlation. And if you look at gold for over a longer period of time, which you can do over at Portfolio Charts, over the past 50 years gold has a compounded average growth rate after inflation of about 6. 2.2%. And that compares to compounded annual growth rate of the stock market after inflation of 8.0%. And as I mentioned, the other nice thing about gold is that it has almost zero correlation with stocks and bonds. So it may be going up when they are going down, or maybe doing nothing like it is today while the stock market's crashing and the bond market's going up. Now, this makes it a great diversifier in almost any portfolio and is a very important upside to gold. All right, so what is the downside? Gold's main downside is its volatility and its unpredictability. It is 1.5 to 2 times more volatile than the stock market. In some decades, it's the best performing asset class out there. In some decades, It's really atrocious. It's really the worst. Now the other downside is because it's speculation, it doesn't have any income. Or if you want to think about it like a financial asset, it's like a bond that pays zero interest forever. There's also a downside if you own physical gold, because you need to secure it properly if you own it in quantity. And if people think you have gold hidden in your house, you could be a target for thieves. or your relatives posing as thieves. There was a tragic story involving a Washington football player last decade. His name was Sean Taylor. And he was known to have a lot of gold in his house, or at least people thought they had a lot of gold in their house. And one night some burglars showed up and they shot him and he died. Now that's not worth the risk. If you're going to own gold, if you're going to own a lot of gold, you better not tell anybody or you better keep it somewhere else or nobody's going to come after it and come after you because of it. All right, who's on the other side of the trade of gold? Question five. Well, there are lots of different people and entities. The largest players in the gold markets are the central banks who periodically will buy or sell gold for mostly for policy reasons. They're really not traders, but they do hold most of the gold in the world. And other large players in the gold markets are big hedge funds, like Ray Dalio's Bridgewater, who will buy tens of millions of dollars of gold at a time or sell it. And then there are the speculators who follow the price of gold around in trade futures. And then there are those physical sellers of gold who put out all those ads everywhere whenever the price goes up. And you know the ones I'm talking about, they tell the gloom and doom scenarios, get people all feared up and primed to buy it and hide it in their basement or yard because of some apocalypse, economic or otherwise. Now longer term, there are also mining companies selling their physical gold, but that actually turns out to be just a small fraction of the total market. There isn't that much gold coming into the market in any given year. So the quantity of it worldwide is fairly static. And there are billions of other individuals around the world that just hold gold as a store of value that's been going on for thousands of years and is more popular in some cultures than others. It's very popular in Asian cultures to hold gold. There are people in countries with weak currencies and weak economies and they tend to hoard some gold. They hoard two things. gold and US dollars. Question six, what is the investment vehicle? This is an interesting question because it has changed over time, especially for investors in the US. Between 1933 and 1975, you could not own physical gold in the US. It was illegal. If you wanted to invest in gold, you either had to keep it outside of the country, or invest indirectly through gold mining companies. Now that changed in the 70s and for about the next 30 years, you could own physical gold in coins or bars, or you could trade gold in the futures markets and that was basically how it was done from the 70s to the 2000s. Now starting in 2003, you could start buying gold and exchange traded funds, ETFs, and gold funds like GLD and IAU are now some of the largest ETFs in the world. They have become the preferred way for hedge funds and most investors in financial markets to own gold, particularly gold in significant quantities. So that hedge fund, that Ray Dalio runs, it's all in GLD and IAU. 20% of that fund is in those two ETFs. Now you often see marketing or opinions or statements touting the virtues of owning physical gold. and there are lots of narratives that I've mentioned about apocalypses, conspiracies. This is all part of gold lore. This is part of the narrative of gold, which has been going on for thousands of years. But these days most of those stories are put out there and promoted by purveyors of physical gold because there are relatively high commissions and storage fees involved and that's what they want you to pay. If you are willing to hold ETFs of stocks, bonds, commodities, REITs, and anything else, ETFs that hold gold are really no different. And if you're not willing to hold gold ETFs, you probably shouldn't be holding ETFs at any other thing or using the financial markets at all. Now in our sample portfolios we are using GLDM, which is just a miniature version of GLD that came out in the past couple years. and its advantage is that it has a lower expense ratio than GLD, so it's a better holding than GLD itself. Now you can also buy gold miners, but those are not the same as gold itself. Gold reacts to things like inflation, interest rates, and economic uncertainty. Gold miners are affected by those things, but they're also affected by technology, extraction costs, local governments, regulation, and competition. Now unlike gold itself, gold miners carry a small but significantly positive correlation with the overall stock market. So if you are interested in gold miners, you should probably analyze them separately from gold. There was a nice article published last week at Portfolio Charts about many of these issues, which I'll link to in the show notes. And it talks about the differences between gold and gold miners. Another issue that it raises or talks about is the taxation of gold because it's a little bit different from other financial assets. Gold is taxed at a maximum of 28%. If your income tax bracket is lower than that, it'll be taxed at a lower rate. But if it's more than that, it's going to be taxed at 28% when you sell it, regardless of whether it's long or short-term capital gains. Now, that article also discusses what drives the price of gold, and it's really not inflation per se like most people seem to think. There's this shibboleth, gold is an inflation hedge. Well, it is sometimes. But many stocks and commodities are just as good or better protection against inflation. What really seems to drive the price of gold when you drill down on it is what is called the real interest rate, which is usually calculated as the yield on a 10-year Treasury bond minus the current rate of inflation. Now when the real interest rate is going down is low or is negative, Gold prices tend to rise. Now nobody really knows why this is the case and why it works that way, but there is a theory that gold acts like a guaranteed bond paying zero percent, which becomes more valuable when real interest rates are really low, because you'd rather have a guaranteed zero percent than a non-guaranteed zero percent or a negative value as some European bonds are paying these days. And this is why gold can do well in periods of high inflation like the 1970s, can do poorly when the rate is still high but it's falling like it was in the 1980s, and then gold can do well again in low inflation environments like we've had for the past 15 or 20 years. So you can't just look at inflation and think you know how gold is going to behave because that's just not all there is to it. You're missing part of the story when you do that. Question seven of our 10 questions. What does it take to be successful to invest in gold? What it really takes for most people is patience. Assuming you're not a trader, we're investors, we're forming portfolios for the long term. You need some patience, because as I said, one of gold's downside is its volatility and its unpredictability. Now this also can be used to your advantage though, because it means that gold can often be making new highs while your stocks or bonds are doing poorly. So in a decade like the 1970s, for example, gold was the place to be, while stocks and bonds were mostly doing pretty poorly or just treading water. Now because this price of gold will swing pretty wildly and widely, it gives you an opportunity to buy low and sell high. But here's where the patience comes in. You usually need to play this out over years or even decades. It's not going to be a month trade or just a year trade or even a couple of year trade. So a patient risk parity investor will set a fixed allocation in their portfolio, say 10%, and be willing to slowly accumulate gold when the price is lower and gold is unpopular, and then start selling it when it makes a run higher like it seems to do every 5 to 15 years or so. So most recently you might have accumulated gold from about 2013 to 2018 when it was mostly around $1,000 to $1,200 an ounce most of the time. And now that it's risen up to about $2,000 in the past year and a half, you could be selling that and buying some other things in your portfolio. Now this rebalancing action is one of the keys and the strengths to a risk parity style portfolio. When some things are going down, other things are probably going up. You can buy low and sell high just by looking at your allocations and rebalancing either annually or within some kind of bands you have set. Question 8 who is getting a cut? Well, depending on the form that you are buying gold in, you have different actors getting a cut. If you're buying it from a dealer, they're going to get their commission, and there might be a significant bid ask spread that they use to make their profits. If you are buying gold in an ETF, the bid ask spread is usually only a penny. The expense ratio for holding gold in an ETF is usually between 0.18 and 0.25% annually, and that's in the most popular funds. I should mention that if you are buying physical gold, gold sellers often also will offer to secure it for you and that's another service that they charge for and so they would be getting a cut out of that as well. Question nine, how would gold impact your portfolio? Well really gold does two things in a portfolio. First, it is hands down the best diversifier from both stocks and bonds. It's like another form of cash that is not subject to inflation. So if you hold even a small amount of gold, like 3% to 5% in any portfolio that is otherwise just stocks and bonds, you would see it tends to perform better, is less volatile, and it really has no impact on the overall returns. It's just a smoother. On the other hand, when a portfolio gets particularly gold heavy, particularly if the gold allocation is more than 20%, it does begin to suffer due to gold's lack of income and high volatility. So if you look at the original permanent portfolio we talked about in episode three, that was a gold heavy portfolio. It had 25% gold in it. and the performance of gold in any one year seemed to dominate all the other assets in the portfolio and kind of dictate how the overall portfolio performed. So that just looks like it was just a little bit too much. There does seem to be a happy medium for gold in a portfolio. It's somewhere probably between 5 and 20%, and our sample portfolios are mostly along those ranges. You can see those on our portfolio page at the website www.riskparadioradio.com and just click on the portfolios page. And it'll list the portfolios and what the percentage of gold is in each one. Question 10. Should you invest in gold? The answer is most probably. Even if you are fond of this relic about a barbarous relic that we've heard, and hate the fact that gold is a speculation. It really can't be denied that it does improve the performance of almost any portfolio in terms of lower volatility. And that is really what you're trying to accomplish with these risk parity style portfolios, because that is what drives your shallower drawdowns and your higher projected safe withdrawal rates. So that's going to allow you to be confident in taking more money out of the portfolio in retirement. But the lesson here also is don't overdo it. And you need to understand why you are doing it. You should not invest in gold because you heard some stories or you believe in speculations about future apocalypses or breakdowns of monetary systems and you shouldn't invest in it because you hear about famous people buying it, or gurus talking about it, or the latest headline, or because the price went up recently, or the price went down recently. None of those factors should be part of your investing process. None. Rather, you should invest in gold because the long-term data and analysis suggests that it's a very good idea in a risk parity style portfolio that will help you with your drawdowns in retirement. And it's certainly a better idea than annuities or reverse mortgages. And now with that, I see our signal is beginning to fade. Tune in next time, which should be this Sunday, for our weekly portfolio review. This week's featured portfolio will be our most conservative one again, coming back to it, the All Seasons portfolio, which we have not focused on since episode two. Now again, you can find those portfolios on the portfolios page at www.riskparadioradio.com. If you have any comments or questions, feel free to email them to me. at frank@riskparadioradio. com that's frank@riskparadioradio.com and I can address them in a future episode if they are appropriate. You can also send a message through the website if you prefer doing it that way. Thank you for joining me today. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [30:55]

The Risk Parity Radio Show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.