Success in investing is not just about capturing the reliable sources of return. It is about reducing or eliminating avoidable risks such as holding too few securities or betting on specific industries. As an example, let’s look at the big bets some people made on gold stocks in recent years.

Gold as a commodity and companies that mine gold hold a particular attraction for some investors, who see the precious metal as a hedge against inflation. Others believe gold is a safe haven in times of market volatility. Some even see it as bolt-hole in the event of the collapse of fiat money.

While the gold price is obviously an influence, the performance of gold stocks also is driven by the underlying businesses and the difficulties in profitably mining the metal.

Back in January 2013, after a difficult year for gold miners, The Australian Financial Review asked analysts about the outlook for the sector. The resulting story (“Goldminers Look Undervalued”) said the sector was oversold and “ripe for investment” 1.

Indeed, one major US investment bank was quoted as saying the gold sector was “littered with opportunity”, with Australian gold equities trading at discounts of 17% to the broader mining index and 28% to the underlying price of gold.

In retrospect, that has been a bad call. In fact, some of of worst performing stocks on the Australian share market from the end of 2012 to November 2014, were gold miners. Indeed, six stocks (Silver Lake Resources, Medusa Mining, Perseus Mining, Troy Resources, Kingsgate Consolidated and Resolute Mining) fell between 80 and 90% over this period.

Over the same timeframe, the broad market, as defined by the S&P/ASX 300 accumulation index, has gained more than 25%. So the gold sector’s performance has been pitiful.

Why have gold stocks failed to live up to the media hype in recent years? Well, the price of gold is one reason. Gold bullion peaked at around $US1900 an ounce in September 2011 and has declined nearly 40% since then to around $US1160, its lowest level in more than four years.

Gold’s recent decline partly mirrors the resurgence in the US dollar, which has climbed to multi-year highs against the Japanese yen, the euro, the Australian dollar and other currencies on the view that the US economy is outperforming other developed economies.

For gold miners who base the profitability of their operations on certain forward assumptions about the price of the underlying commodity, the market performance of gold is obviously a concern.

But stock-specific issues also influence these companies. Prospects are often in far-flung and inaccessible parts of the world. Miners can face long lead times and regulatory hurdles between prospecting and actually mining gold. Development costs frequently escalate and sourcing skilled labour can be a challenge. On top of that, there can be significant variation in grades, which refers to the proportion of gold contained in the ore of a particular mine.

These factors all represent substantial uncertainties for investors in gold companies. Of course, the potential rewards can be significant, but so too can the risks.

None of this is to say that gold as a commodity or gold stocks should not have a place in a diversified portfolio. But it is a warning against building an investment strategy around opinions about the outlook for a particular industry or market sector.

This is why diversification is an essential tool for investors. While it will never eliminate risk completely, diversification does help lessen the random influences governing individual stocks and sectors and positions portfolios to capture the returns of broad economic forces.

Of course, it is possible to hit the jackpot with a bet on an individual sector. But this is not a replicable or scalable strategy and if you don’t strike it lucky, there’s nothing to fall back on.

There may be gold in them there hills, but it won’t necessarily make you rich.

 

Article by Jim Parker, as part of his Outside the Flags collection

References

1. ‘Goldminers Look Undervalued’, Australian Financial Review, Jan 20, 2013

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