Silver's volatility is not for the faint hearted
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
In the previous section of this series CPM Group discussed silver's historical outperformance relative to gold and our expectations for silver prices in the medium term. This second part of a three-part series discusses the risk associated with owning silver.
Silver's outperformance relative to gold comes with significantly higher risk. The same factors – smaller market size and relatively lower liquidity – that help silver outperform gold on the upside (for reasons described in the first part of this series) are responsible for the sharper drawdowns in silver prices. Silver is the only precious metal which has a leptokurtic distribution, a distribution type that has fatter tails than a normal distribution. These fatter tails suggest higher probabilities of extreme outcomes.
Silver is a high risk-high return asset. While there is some benefit to adding silver to a portfolio as a strategic asset, given the higher level of risk associated with the metal, silver is probably better for trading in and out of than for strategic allocation in a portfolio.
CPM Group constructed 450 separate portfolios which contained equity, debt, and various combinations and weightings of the four exchange traded precious metals – gold, silver, platinum, and palladium.
Some of the broad conclusions that were drawn from this study were that the addition of any precious metal or combination of precious metals to a portfolio invariably improved the return to risk ratio of that portfolio – based on historical past performance.
The greatest benefit to the risk return profile of a portfolio was achieved by the addition of only gold to a portfolio of stocks and bonds, however. Various combinations of precious metals were able to raise the return to risk ratio very close to the gold-only portfolio, but because they had higher risk (boosting the denominator) they required higher proportions of precious metals to do so.
Based on our studies, gold's relatively low volatility compared to its precious metal peers makes it the best addition to a portfolio. The long-term median volatility of gold prices stands at 15.3% compared with 25%, 20%, and 27% for silver, platinum, and palladium, respectively. As a result, it was determined that diversifying a stock and bond portfolio with gold would improve the overall portfolio performance with less reduction in potential returns than would the more volatile other precious metals. As an example, adding 10% of gold to a portfolio raises that portfolio's Sharpe ratio to 0.43 from a Sharpe ratio of 0.33 for an only stock and bond portfolio.
Adding 10% of silver to a stock bond portfolio, meanwhile, raises the Sharpe ratio to 0.37. The discrepancy in the sharp ratio continues to widen as more of the precious metal is added to either of the portfolios.