**Q: Hi Chip, **

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**Is there a fair value for gold? How do you compare the gold and silver price to determine which one is under valued?**

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A: One of the tools I use to determine the fair value of any asset is valuation ratios. With respect to gold, one such ratio is the price of gold in relation to the price of silver. The graph below shows the historical pricing relationship of the gold and silver since the breakdown of the Bretton Woods system in the early 1970s (before that, the gold price was fixed):

For the first decade after the breakdown of the Bretton Woods system, the gold/silver ratio hovered around 35. Since then, however, the gold/silver ratio has averaged about 65. While the **ratio** has been volatile over the last 30 years, the **average** has been pretty steady. In fact, back 24 years ago (May 1986), the ratio was exactly the same as it is today, 66 (very near the long-term average).

This convenient truth allows us to look at an excellent example of the power of rebalancing. In the 24 years since May 1986, gold returned 5.39% per year and silver returned 5.32% per year. I specifically picked this starting date because the returns are almost identical. Now, let’s look at the power of rebalancing.

If, 24 years ago, I had simply divided my precious metals portfolio 50/50 between gold and silver AND never touched it again, today my precious metals portfolio would be up 250% or 5.36% per year. It would have been a wild ride with monthly volatility of 5.42% per month and 17.78% per year.

In contrast, if I had rebalanced my 50/50 portfolio monthly, today my precious metals portfolio would be up 293% or 5.87% per year. It still would have been a wild ride, though, with monthly volatility of 5.39% per month and 17.94% per year.

Looking at the graph, it’s clear that the gold/silver ratio can vary a lot. The graph below shows the 95% (2-standard deviation) bands around the average from 1982 to the present.

From this graph, we can see that since 1982, the ratio has averaged 65 and been between 42 and 88 (based on standard deviation).

- From 1983 to 1991, the ratio rose from 31 to 99. During this period, gold outperformed silver. Gold lost 1% per year, but silver lost 15% per year.
- From 1991 to 1999, the ratio declined from 99 to 47. During this period, silver outperformed gold. Gold lost 4% per year, but silver gained 5% per year.
- From 1999 to 2003, the ratio rose from 47 to 80. During this period, gold outperformed silver. Gold gained 10% per year, but silver lost 5% per year.
- From 2003 to 2006, the ratio declined from 80 to 46. During this period, silver outperformed gold. Gold gained 18% per year, but silver gained 38% per year.
- From 2006 to 2008, the ratio rose from 46 to 80. During this period, gold outperformed silver. Gold gained 12% per year, but silver lost 14% per year.
- Since 2008, the ratio declined from 80 to 66. During this period, silver outperformed gold. Gold gained 30% per year, but silver gained 48% per year.

In short, gold did better when the ratio was low and rising, silver did better when the ratio was high and falling. Based on this track record, it appears that (at least historically) I could have done better than just rebalancing to a static 50/50 precious metals allocation. I could’ve improved my performance by using a dynamic rebalancing strategy, changing my allocation based on the gold/silver ratio so that I was favoring gold when the ratio was low and favoring silver when the ratio was high.

As an example, I could’ve based my allocation on the simple strategy of investing 50/50 when the ratio is 64 (average), 75% silver if the ratio is 88 (2 standard deviations above average) and 25% silver if the ratio is 42 (2 standard deviations below average). This would’ve improved the return to 437% (since 1982), or 7.26% per year. The downside is that I would’ve increased the volatility to 5.41% per month and 18.58% per year.

To reduce the volatility, I could’ve taken advantage of the fact that gold has been less volatile than silver. Leaning more toward gold, reduces the volatility without significant reduction in return. For example, by investing 50/50 when the ratio is 75, 75% silver if the ratio is 100 and 25% silver if the ratio is 50, the volatility drops to 5.07% per month and 17.62% per year, but the return is still 427%, or 7.14% per year.

The final tweak involves getting even more aggressive with the dynamic rebalancing. For example, by investing 50/50 when the ratio is 75, 100% silver if the ratio is 100 and 0% silver if the ratio is 50, the volatility drops to 4.89% per month and 17.49% per year, but the return goes up to 583%, or 8.34% per year. This is an excellent example of the power of dynamic rebalancing. If I had just purchased $1000 worth of gold and $1000 worth of silver, and let them sit for 24 years, I would now have $6,995 worth of precious metals. If, instead, I had used the dynamic rebalancing process, it would be worth $13,666. And, the portfolio’s value would have been less volatile over the 24 years.

This is only possible because while gold and silver have exhibited similar returns over long periods, they have not been perfectly correlated. Taking advantage of these types of relationships is very important to the success of the ** Plumb Performance Portfolio^{©}**, but it’s important to realize that this success is dependent on the continuation of past behavior patterns.

Question, Dear Chip,

I see that at present you are veering towards more silver and less gold… this despite the fact that the gold/silver ratio is largely in favor of gold, as it is around 37…….if the “median” is around 65…and therefore logically the ratio should be returning to this mean…why wouldn’t we want to ride the gold as it returns upwards… Isn’t the present ratio favoring gold at present?

… Or do I have it all wrong and should just stick to painting?

Best wishes…ps.. I have been noticing that silver has been out performing gold as of late, tho both are doing jus’ fine…….

Bruce