Diversification: the only free lunch in investing

According to Nobel prize laureate Harry Markowitz, when it comes to investing, “diversification is the only free lunch”. If you’re using stocks and bonds to build a portfolio, you are only using a small part of the investable universe, and many investors look right past powerful portfolio diversifiers such as gold. To this end, diversification is a vital part of portfolio construction needed to meet an investor’s objectives — whatever they may be — with the highest degree of reliability and certainty as possible.

To explain, let’s start with a common-sense investment objective: reliably grow your portfolio’s purchasing power as rapidly as possible and minimise the risk of loss. An immediate reaction might be that taking limited risk places a constraint on a portfolio’s return potential. However, the exact opposite is true. Rather than being a limitation, reducing risk is an essential aid to all three “r” points: (a) reliability of success, in achieving; (b) rapidity of growth; simultaneous with (c) low risk of loss.

The simple reason for this is the asymmetric effect of gain and loss known as Siegel’s paradox. It takes a 100% gain to recover from a 50% loss, and a whopping 900% bounce-back to recover from a 90% loss. By definition, downside control translates into meaningful return enhancement. This is where diversifiers — such as gold — come into the story.

What does gold do?

Gold’s name has common roots with the Afrikaans and German geld (money), and Dutch gulden (currency), which reveals something about gold’s attribute as a monetary asset. However, gold differs from printable currency (“paper money”) in that it cannot be created by fiat but must be mined from the earth. Gold has a fixed supply compared to easily printable fiat currency. To the extent that there is a demand for gold as a hard backing for money, the limited supply will ensure its price is well supported, at least far better than that of overprinted fiat.

Physical gold hedges the exposure that other assets have to monetary inflations, which are not limited to price inflation, and include supply disruptions because an unstable medium of exchange makes it harder to do business. The extent of gold’s power is evidenced by central banks holding the precious metal to back their currency, discipline their ability to print money and, in so doing, serve as a hedge against deteriorating monetary conditions.

This summarises the conceptual case for gold: it is not necessarily a sure thing, but a “maybe” thing that may be just about the only thing — alongside inflation-linked bonds — that can protect against a serious bout of stagflation.

Empirical analyses on gold

Here, however, challenges quickly emerge, with one of the most common being to compare gold’s returns to realised inflation. A regression of monthly gold returns on consumer price inflation for the US over 25 years shows virtually no relation. This readily supports the complaint that gold is a feeble inflation hedge.

But this conclusion misses a key point. If we apply the same method to US inflation-linked bonds over the same period, we are led to the same strange conclusion: even though inflation-linked bond coupons are directly linked to inflation, they have no relation to inflation. This sounds wrong, because it is wrong!

A different — and corrected view — of gold and inflation-linked bonds is that they help manage the risk of changes to inflation and economic growth expectations going forward, and not backward-looking realised results. That is because markets price assets based on expectations. From this, one would expect gold and inflation-linked bonds to at least have some (even if imperfect) similarity to one another. This is exactly the case, as shown over the past 20 years. Even more important, and returning to the diversification point, they behave differently to US equities (S&P 500) and produce a better return over the measured period. This is the free lunch of diversification, which is earned by viewing gold’s relationship with inflation through the correct lens.

But how does this relate to the trinity of objectives of reliable, rapid growth at low risk of loss? The real glory of stagflation assets — such as gold — is how they can be combined with disinflationary boom assets like equities to create a risk-balanced portfolio that is better than either asset class in isolation. This is evidenced by the zigzag pattern between equities and gold caused by the fundamentally juxtaposed exposures to monetary and real economic supply and demand conditions (consider the early 2000s or 2015 to present). When held together in a diversified portfolio, the basket produces growth that is more reliable, just as rapid and with much lower real risk of loss. This is the power of diversification.

The above shows what is possible with two fundamentally different exposures that are risk balanced with one another. More can and should be done (by including more asset classes across a greater spread of geographic-economic blocs) to not place at needless risk the wealth saved up today to meet the needs of the future.

Gold is not perfect, but that is the wrong standard anyway. The important point is that a portfolio is radically improved by including some of it, and that is the pragmatic, even central, point to take away. Some call it portfolio construction; Markowitz called it a free lunch.

• The authors are investment specialists at Genera Capital.