Almost two years ago I wrote about why diversification is not a free lunch. Now I’m watching everyone dive into gold, and me need to say something. Four years ago, inspired by PortfolioCharts, I wrote this about gold.
But that was back then, when no one cared.
Today? Everyone buys it. And I think I know why: after gold’s massive run, the time has come feels such as free diversification. The psychological appeal is clear:
- You don’t sacrifice returns (gold crushed it)
- It is a diversification tool (protection if overvalued stocks crash)
- Everyone else is doing it (social proof is powerful)
Here’s the thing: gold is a long-term diversification tool. But in the short term, especially considering what it has done recently, it will probably behave exactly like stocks.
It’s a diversifier simply because it does its own thing.
Think of how many times you’ve heard someone complain, “I was promised bonds were inversely correlated with stocks!” Well, not really. Assets can be negatively correlated for years, and then positively correlated for just as long. There are some structural reasons behind every relationship, but you have to think of it as valuations: it takes time to really matter (and you have to look at the right reasons).
I don’t think a gold crash would drag stocks down. But the opposite? That’s likely. If stocks collapse, gold will follow.
The leverage problem
As Cem Karsan often says, the market itself is the biggest contributor to market liquidity. Gaining leverage is simple: your assets increase, you borrow more, you buy more assets. I’m not trying to sound like a doomsday YouTube channel here, this is just how markets work. Most people even do it responsibly. But it still stimulates the markets in a huge way.
When that engine reverses, liquidity quickly evaporates.
And this is what happens: Stocks fall and investors get margin calls. They need to liquidate something. And gold? It is the perfect candidate: very liquid and up significantly.
The liquidity cascade
That’s what Corey Hoffstein calls it. Investors faced with sudden losses or margin calls rush to sell assets to raise cash. They sell not only their worst performing stocks, but often also their safest investments, because these are liquid and need to be rebalanced. Although gold is usually seen as a safe haven, investors can be one in the event of a serious crash forced to sell it to cover losses elsewhere.
The mechanisms are simple:
- Investors desperately need cash, so they sell whatever liquid is available
- This creates a ripple effect: more sales leads to lower prices
- Even ‘safe’ assets are being swept up in the selling pressure
The price of gold can fall even if the long-term fundamentals (whatever they are) remain valid.
The inevitable complaints
I’m already preparing for the flood of complaints when this happens: “I was promised that gold was not correlated with stocks!!1!”
But that’s exactly it Why Diversification works: not because assets never move together, but because these relationships change over time. Diversification has worked in the past and will work again in the future precisely because nothing is a guaranteed safe haven in every market environment. Especially if you are fixated on the short term. The more something has worked in the recent past, the more investors will jump in… and the more likely it is that the same strategy will not work in the future. Rinse and repeat.
Diversify your diversifiers.
First and second responders.
The investors who understand this, who know that correlations are dynamic and that short-term behavior can diverge wildly from long-term patterns, are the ones who stick to their strategy when everyone else is panicking.
So before you add gold to your portfolio because it’s had a great run and “everyone is doing it,” remember: there’s no such thing as a free lunch. Not with diversification, not with gold, with nothing.
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