Risk

At a recent Investment Management Committee meeting we were discussing the importance that gold plays in our portfolios.  Over the past year, many clients have asked if we had exposure to gold.   To their surprise, we let them know that we have always maintained exposure to gold in our portfolios via investments in several mutual funds that have consistently maintained an investment in gold bullion (specifically the IVA Fund and First Eagle Global Fund).  Recent events and our ‘Muddling Through’ strategy to hedge our portfolios have convinced us that this exposure is more important than ever and should probably be increased.  This article, therefore, is not so much about our outlook for gold as it is about the importance gold plays in managing the risk of a portfolio.

Gold has been used as a medium of exchange and store of value since as early as 1500 B.C. and it continues to serve that purpose today.  Many investment professionals believe that Gold serves two key functions in a well diversified portfolio; (1) as a direct hedge against inflation and (2) as a “shock absorber” during periods of severe financial stress.

Government debt levels in many developed countries (U.S., U.K., Japan, Spain, Italy, Greece, Portugal) are at unsustainable levels and growing.  The recent financial crisis has been a significant contributor to this problem.  Central banks have largely responded with solutions that involve the purchase of various debt securities with “money” that is simply created, often referred to as printing money. This is likely to be the continued playbook for dealing with the European debt crisis.  Although the data is choppy, we are already seeing the impact on the general level of prices. 

We are currently looking an opportunity to increase our portfolio allocation to gold through investment in a gold bullion ETF.  While we recognize that gold has already risen steadily over the past decade, we believe inflation pressures are building and see the recent 15% pullback as an opportunity to add to our current exposure.  We also recognize that Gold can be a volatile asset, but see the longer term inflation protection benefits worth the potential volatility that such an investment might add to the portfolio.

(Click on Chart to Enlarge)

Part of our ‘Muddling Through’ strategy is having flexibility, liquidity and the right balance of asset classes with low correlations, to each other, to help dampen overall portfolio volatility.  Having the right amount of equities, fixed income, commodities (gold) and cash, for a specific risk levels, is what really controls the majority of the portfolio’s volatility.

Portfolio Strategy

We just completed a series of Investment Committee (IM) meetings to review our portfolio strategy.  We started with a view of the world’s investable capital and how it is distributed.  The purpose of this exercise is to become more informed on the changes to the relative size of the various markets and to relate that information to our asset allocation decisions.  For example, U.S. Stocks represent 14% of the $104 trillion global market, while emerging market stocks represent 2.6% of the entire market.

Next, we develop our risk models to make decisions on the basic asset classes, stocks, bonds, commodities and cash.  We then decide how much we want to allocate to domestic vs. international in these categories.  The process continues to drill down further.  For example in the bond class we decided how much exposure we should have for international and within international, how much should be allocated to emerging market bonds.  As you can see, this takes some time to complete.  Only after we have identified all the sub-categories, do we begin to select specific investments for each category.

During the process we remain focused on the long-term, but remain vigilant that there are shorter term events that can impact our portfolios.  However, the outcomes of these events are currently unknown.  I keep reminding everyone that while we may know what needs to happen, we need to base our decisions on what is likely to happen. 

Here are some of those short term events in the U.S. that we are watching:

• During this quarter, Congress will vote on the 2012 Budget Appropriations Bill
• On November 23, 2011 The Super Committee will make its recommendations for cutting the U.S. Budget
• During first six months of 2012, the Presidential primaries will make clear who the Republican Presidential candidate will be to run against President Obama in the November election
• Sometime in the summer of 2012, The Supreme Court will begin reviewing the Obama Health Care Mandate
• In November 2012, the Presidential election will be decided

Each of these events will help us become clearer on the direction of our economy.  Keep in mind that markets climb a wall of worry.  The market is a discounting mechanism for the future of our economy.  It will begin anticipating the outcome of the election sometime in the first or second quarter of next year.

There are many other global factors that need to be considered in our decisions.  The European situation will have to be resolved one way or another. They need to choose the least destructive path for the citizens of the European Union (EU). 

As these events unfold we will gain more clarity.  In the meantime, we remain very defensive and flexible with our portfolio strategy.

We will begin implementing changes to our strategy this month.  It calls for rebalancing some of the asset classes and a change to some of the funds we want to use going forward.  As always, if you have any questions about your portfolio, please call and we will be happy to discuss.

Wishing you all a great Thanksgiving holiday!