Another Golden Lesson For Asset Allocation & Rebalancing

Maybe it's the sell recommendation from Goldman Sachs. Or perhaps the trigger is the general fear of a sharp slowdown in China's economy that will take a toll on global GDP. Whatever the reason, the price of gold yesterday suffered it's biggest drop in 30 years. For gold bugs who loaded up on the precious metal, it's been a rough 24 hours. Of course, if you really believed the seers who say gold's going to $5000, you'd be buying more after yesterday's price crash. But that's a tough call for the simple reason that estimating expected return for gold—and commodities generally—is unusually tough compared with stocks, bonds and real estate. Gold, after all, has no income, produces no earnings, and has no fundamental economic value beyond its limited industrial applications.

That's not to say that commodities provide no value in an asset allocation context. Au contraire. Raw materials are one of the major asset classes and, in theory, deserve respect when it comes building diversified portfolios. In practice, however, commodities are complicated, for several reasons, starting with the fact that it's hard if not impossible for most investors to own barrels of gold, bushels of wheat, and bars of gold.


Exchange-traded products have to a large degree solved this hurdle by securitizing hard assets. But there are some factors that can't be securitized away, including the fact that commodities are inherently speculative assets. Stocks, bonds and real estate, by comparison, are true investments in the sense that they produce cash flows that can be analyzed to estimate the underlying value of the assets. It's still hard to predict returns for, say, equities, but it helps to know how price compares to earnings or dividends on any given day.

By contrast, how much is an ounce of gold worth? The answer, ultimately, is a speculative one and relies primarily on guesstimating how much the crowd will pay tomorrow.. Still, commodities have diversification value, as numerous studies have pointed out. But some folks take a reasonable point and run it off the cliff by obsessing over certain commodities at the expense of other assets. That's asking for trouble eventually, and the caveat applies to all the asset classes.

But sometimes the extreme looks reasonable. Gold's dramatic rise over the last decade has supported any number of forecasts that say chaos and mayhem are just around the corner. But the world economy, despite the ills of the last five years, is still standing and there's a good chance that more of the same is coming. Perhaps the gold bugs have finally decided that survival is in the cards after all.

As for gold's latest tumble, and the bearish aura it seems to have cast over oil and other commodities, the sharp drop in price represents an intriguing opportunity for those of us who continue to embrace the fundamental strategy of prudently diversifying across the major asset classes and rebalancing the mix regularly. No wonder that a simple application of these two crucial techniques in portfolio management tends to perform competitively against a wide array of strategies intent on doing better.

Why? There are several reasons, although it starts with the fact that markets have a habit of surprising even the smartest investors with sudden bouts of volatility. That's never going to change, which why broad asset allocation and routine rebalancing are likely to remain perennial winners in relative if not absolute terms.

How does this relate to gold? Well, if you've been riding the gold train all along, you should have been periodically rebalancing and paring the metal's weight in your portfolio. Systematic rebalancing isn't all that smart if you have a high-confidence view on what's coming. But how many of us have access to such wisdom on a regular basis? Let's see a show of hands... Ah, I thought so.