Perhaps the most important clichéd line for investors is “don't put all your eggs in one basket”; surprisingly, however, many investors fail to grasp the essence of this advice. Equity investors commonly diversify their portfolios by purchasing stocks from a number of different companies.

It is a great way to reduce company-specific risks: for instance, my portfolio is still good after X company’s stock tumbled, since I have 24 other companies in my portfolio. Going one step further, buying the entire market by purchasing an index fund is a popular investment strategy, and it indeed diversifies away all of the company-specific risks, leaving us with what is called “systematic risk”, or in other words, the risk associated with the entire market.

Preparing for the rainy days

Investing in the stock market is like running several businesses. Running a sunscreen shop on the beach could be a viable business. Yet, you could further diversify away your risk of people not liking your sunscreen by selling a few other items, such as sunglasses, hats, and drinks. However, when a rainy day comes, you might still bear a loss despite your wide selection of sunny-day items. Hence, you might consider adding umbrellas to your inventory, as a way to prepare for those rainy days.

The same principle holds in stock investment. A great deal of risk can be diversified away by investing in numerous companies. However, nothing will save your investments when the entire market experiences a free fall (i.e. when a “rainy day” comes). Therefore, let’s talk about the equivalent to the “umbrellas” for stock market investment.

To reduce the risk of severe losses when the entire market goes down, we need to add investments with zero or even negative correlation with our current portfolio. This means that when the majority of our stocks tumble, these investments will stay intact or even go up. Besides putting eggs in different baskets, how about putting some eggs in a safe? A possible solution? Gold.

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Gold has been a part of many civilizations for hundreds of years, if not thousands, for multiple reasons, including its value-holding property against inflation. Although the precise relationship between gold price and stock market performance remains debated, academic works have shown that gold can serve as a decent hedge against stock market downturns and possibly inflation as well.

In essence, the stock market reacts well to economic strength; however, gold price is more correlated with the level of economic distress. As a long term investor, it helps me to sleep tight at night knowing that even if the market tumbles tomorrow morning, my loss will not be as scary, because the price of my gold investments will likely go up and provide a nice buffer against adverse market situations.

Of course, cuddling your gold bars at home might not be the best risk-reducing action to take, for obvious reasons. If you absolutely love the feeling of owning physical gold, the safety risk could be reduced by purchasing gold bullion and saving it in a safe deposit box in your bank. However, liquidity can sometimes be an issue. For example, bank hours are limited; if the gold price surged today and you do not see the trend lasting, you will need to rush to the bank, talk to a teller, see a dealer, and sell your gold for cash.

Investing in gold ETFs

Instead, trading gold on my phone through a gold ETF provides me with both liquidity and convenience, as well as safety. ETF stands for exchange-traded-fund. They are traded on exchanges the same way stocks are, but they can be structured as an index fund, specialty fund, or representing precious metal holdings, among many other possibilities. The main benefits include low cost and high liquidity (meaning sellers and buyers are readily available). More information about ETFs can be found here.

There are a number of ETFs that provide investors with exposure to gold. Here are a few of them that are listed on the Toronto Stock Exchange:

iShares S&P/TSX Global Gold Index ETF (XGD)

This ETF provides a targeted exposure to global securities of producers of gold and related products – It is a bundle of 48 stocks from companies that are in the gold mining business. These companies’ profits are closely tied to gold price. – Note: this ETF does not represent a direct ownership of gold; instead, investors still face the operational risks of the underlying companies (e.g. inadequate management, financial stress, etc.)

iShares Gold Bullion ETF (CGL.C)

This ETF provides a targeted exposure to the price of gold that is unhedged to the Canadian dollar. Its underlying asset is physical gold. Note that, although it represents direct exposure to gold, Canadian investors still face a currency risk when buying this ETF.

iShares Gold Bullion ETF (CGL)

Its underlying is identical to that of the previous ETF, but hedged to the Canadian dollar. It is the most straightforward method of owning gold directly through an ETF for Canadian investors

Horizon Gold Yield ETF (HGY)

This ETF provides an exposure to the price of gold bullion hedged to the Canadian dollar, with an additional feature providing monthly income. Besides providing direct exposure to gold, it employs the “covered call” strategy to generate continuous income to the unit-holders of this ETF. (A call is an option, which allows one to purchase the right to buy securities at a predetermined price; to obtain this right, the investors pay a fee called a “premium” to the option writer. In this case, the issuer of this ETF acts as a call writer with gold as the underlying asset, and the continuous income the ETF generates come from the proceeds of the premiums that the call option buyers pay.)

The above listed ETFs are among dozens of gold ETFs available on the markets, and these four ETFs are the relatively straightforward ones. There are also gold ETFs that are leveraged and those incorporating various derivative strategies.

How much gold should you keep in your portfolio?

Another question remains, how much gold investment is appropriate? We incorporate gold into our portfolio to hedge the rainy days, but what if sunny days persist? Since gold return tends to be unrelated or negatively correlated with stock market returns, investors holding a large position in gold might receive unsatisfactory portfolio returns when the stock market is running hot.

The exact percentage of gold to hold in one’s portfolio depends on a number of factors, such as the risk level of your present portfolio, your level of risk-aversion (i.e. how paranoid you are) and your outlook on the stock market.  

For example, Kevin O'Leary, a successful Canadian investor, disclosed in an interview that he has 5% of his portfolio in gold. When the gold price goes up, he sells the “profit” portion to reduce his gold position back to 5%; when the gold price drops, more gold is purchased to replenish it back to 5%. Therefore, 5% is the relative weight of gold investment in his portfolio. If one wished to follow this strategy, it would be up to us to set our own relative weight percentage, which would take our own unique situations into account.

As a side note, although I personally think constant rebalancing an investment’s weight in a portfolio can be a brilliant strategy, it does not apply well to small investors, due to the high transaction costs relative to the invested amount. Instead, it makes more sense for small investors to trade less frequently, to avoid incurring high transaction fees.

Finally, as classic and quotable as usual, Warren Buffett describes gold investment as a value preserving tool, instead of a value generating one. I quite agree with his outlook on gold investment, and it’s important to stay cautious on every investment, including hedging tools. Stay foolish, stay hedged.

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