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From FT Alphaville:
Since the peak in early September, 2011, the dollar price of gold has plunged more than 40 per cent. Given the human tendency to expect the future to look like the recent past, sentiment seems to have become relentlessly bearish.
Hedge funds have gone net short gold for the first time since data began being collected in 2006.
For the sake of argument, suppose you agree with this “smart money”. (Maybe you were persuaded by this or this.) What should you do?
Knowing the strength of your conviction and your risk tolerance is necessary for determining whether you should simply stop buying more gold than you already hold, go to the other extreme of dumping everything and loading up on ETFs like this, or something in the middle — but it’s not sufficient.
To articulate your view into an actual position you also need a sense of what constitutes “neutral”. In other words, how much gold, if any, would you own in a purely passive savings portfolio?
Figuring that out is far from straightforward, but we’re going to attempt to give some suggestions on how to think about it. (We also tend to think it’s a far more interesting question than whether the price is going to go up or down.)
It’s entirely possible that even someone with a moderately bearish view on gold should still own some of the shiny metal.
The standard way to think of portfolio allocation is to just add up the value of all the assets in the world and allocate savings proportionately. This, essentially, is the logical conclusion of the efficient market hypothesis: trust the collective wisdom of every other investor, trader, and asset issuer to tell you how much of anything you should own, and you’ll do better than if you tried to make specific bets on relative value. A nice feature of market weighting is that, in theory, everybody can do it.
For example, Apple’s equity is worth about $676 billion while all the world’s public companies are worth around $74.6 trillion as of pixel time. If you use market weights as your benchmark, holding less than 0.9 per cent of your stock portfolio in Apple shares therefore means you’re expressing a bearish view on the company. (Note that by this logic most people vastly overweight companies in their own country relative to companies in other countries, a well-known puzzle among finance academics.)
Gold also has a market value. The World Gold Council estimates that there are 183,000 tonnes of gold above ground, and this number doesn’t move around too much because consumption and mine output are both small compared to the extant stock accumulated over thousands of years. The current market value of these shiny rocks is around $6.4 trillion. That’s almost exactly 9.5 Apples, or about 8.6 per cent of all the world’s public companies. You could, therefore, conclude that for every $100 you currently have invested in equities, you should have around $8.60 invested in gold.
But what if market cap weighting is wrong?...MUCH MORE
