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Gold as a diversifier in the family business portfolio

"It'll never happen to me" is not an effective approach to risk management. Family businesses are vulnerable to events such as changes in ownership, family affairs and commercial issues. While nothing can provide absolute protection against all eventualities, much can be done to manage the risk associated with the investment of family wealth. Protecting the family's assets against potential financial trauma is the responsibility of the family office. However, family members whose funds are being managed can benefit from understanding the methods used to safeguard their wealth.

Family offices, charged with the preservation of wealth, naturally want to reap the benefits from years of plenty and avoid seeing their assets waste away during years of famine. If it were possible to anticipate lean years with any degree of certainty, it would be easier to make provision for them. However, disaster strikes with little warning and more frequently than one would imagine. To insure one's assets adequately in an uncertain world, it is essential to anticipate realistically the risks to which they may be exposed and to take the appropriate action to provide security in times of trouble. Having a suitably diversified investment portfolio and ensuring it contains investments robust enough to weather the impact of financial storms is crucial.

Markowitz, the father of modern portfolio theory, is reported to have observed that the question he is most often asked by his barber is, "So how is the market doing this week?"Professional investors, on the other hand, ask him about the distribution of returns. That is because the distribution of returns determines how exposed the portfolio is to risk. Put differently, it determines how likely it is that the investor will lose a given sum of money. Unfortunately, many risk measures underestimate the extent to which value is at risk because they fail to take into account just how frequently extreme events occur – a phenomenon described in the trade as the 'fat tail' problem. In the context of portfolio management, an extreme event is defined as investment returns that are either greater or lesser than two standard deviations from the mean, or expected, return.

Risk and return
As a general rule, when deciding whether or not to make an investment, the investment manager takes into consideration the expected return on each asset and weighs this against the risk attached to that return. Risk is typically measured in terms of volatility: the more volatile the returns on an investment, the riskier it is deemed to be. Therefore, when looking at an individual asset, the investor is concerned with two criteria: risk and return. It is generally accepted that there is a tradeoff between risk and return; the riskier the asset, the higher the return should be, given that markets are efficient.

What holds true for individual assets changes somewhat when considering a family business's portfolio as a whole. This is because the risk-return characteristics of the component assets interact, impacting on the final outcome. It is this interaction that makes diversification possible, since including assets which are poorly correlated with each other reduces overall portfolio risk for a given return. It is precisely this quality which makes gold so valuable as a diversifier.

Withstanding extreme weather
The inclusion of a small proportion of gold in a family business owner's portfolio makes it possible to increase the weight of higherreturn, riskier assets such as equities, whilst maintaining a constant level of risk. This is because the diversification offered by gold is effective when it is most needed. Including gold in a portfolio can also help to reduce the fat tail problem, strengthening the probability that benchmarks will be met. Family offices and investors who recognise the role that gold can play in reducing exposure to the elements have a better chance of withstanding extreme weather.

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