After deciding that investing in gold is the right move for them, many investors want to know: how much gold should you invest in compared to their other assets? Does gold follow the normal rules of diversification? Should gold be held in place or stocks, or in place of cash? One thing is certain: understanding the particulars of gold in portfolio diversification is important to making wise decisions.

What kind of diversification does investing in gold give me?

Gold provides a particular kind of asset diversification. Consider this: Investing in gold or converting your 401k to gold has two primary goals. The first is as a simple security blanket. In case of financial disaster, the likelyhood of gold emerging as at least a temporary currency is quite high, so holding some physical gold locally that can be used in such an emergency is one role. This goal has little to do with portfolio diversification. You can’t exactly buy bonds to serve this purpose, after all. The second goal is use as a countercyclical currency alternative, and it’s this role that is important when considering diversification.

Investing in gold is much more similar to investing in a currency than it is to investing in stocks or bonds. When you invest in a stock or bond, you are giving money to a company that will use it to do something productive: build factories, hire workers, or otherwise create products and services to sell. When you invest in a currency, however, you aren’t investing in productive growth. Instead, you buy the currency due to expected future changes in the purchasing power of the currency. You think at some future time each unit of the currency will be able to purchase more of the products and services you want. When you buy stock you are using the investment to build value. When you buy currency you are using the investment to hold value.

These currency holding opportunities are more or less a vote of no confidence in the other investments that are available to you. For example, if the entire market is dropping in value you can leave the market entirely, move to dollars, and then buy back into market at a later point when your dollars have more purchasing power. Trading in currency alternatives is no different. If the value of the dollar itself is dropping, or if markets are trending downward, then gold and similar investments will rise in relative price, preserving the value of your current stock of wealth. In the case of gold, there is some demand as an industrial product that gives it somewhat of a price floor, but the majority of the large movements in the price of gold are related to its current demand and value vis-a-vis other currencies and as a hedge against market-wide movements that occur during recessions.

What kind of diversification doesn’t it give me?

If you talk to a financial advisor about your portfolio, he may say something like “you are too heavily weighted into tech stocks. You should diversify out into, say, energy stocks to reduce risk”. What the advisor is talking about is sector diversification. Unlike asset diversification, sector diversification doesn’t recommend that you leave stocks or bonds or currencies, it simply recommends that you not have all of your stocks or bonds in one industry, or (less commonly) not hold all of one currency.

Gold certainly provides sector diversification – after all, it isn’t a tech stock or manufacturing bond – but it doesn’t excel at it. There may be times when gold outperforms one stock sector but not another, however the relatively high transaction costs of most forms of gold make it a bad purchase for the level of trading activity required to keep ahead of these short term trends. Gold fares better as an investment with longer reallocation terms and less fickle trends.

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