Summary

• Using SLV correctly can reduce the standard deviation of returns in a portfolio.
• Using SLV incorrectly leads to excess diversifiable risk.
• SLV’s low correlation with the market should produce a lower beta than the publicly reported ones.

Investors should always be concerned with risk. A major difference between the successful investors and the unsuccessful ones is how they manage risk. The concept of Alpha relates to returns in excess of the return expected to compensate for the risk of a portfolio. However, many investors focus strictly on individual securities rather than taking a careful look at the composition of the entire portfolio. I want to address the role of (NYSEARCA:SLV ) in the composition of an entire portfolio and why I think any large exposure to a single risk factor is likely to generate negative alpha.

One way I measure risk is to look at the standard deviation of returns to the portfolio. In my opinion, a focus strictly on the returns to the portfolio undervalues the impact of reducing the risk inherent in the portfolio. In my opinion, historical statistical data is better suited to projecting correlations and risk than to projecting returns. Yes, return projections can be made using beta under the CAPM theory, but I think there are some weaknesses to that approach. What we are really measuring is the covariance of returns. If you want to get technical, we are measuring the covariance and the variance. Then we are plotting the slope of the resulting equation.

While there can certainly be some historical bias in the data sets, the standard deviation of daily returns can be a very useful measure. I’m operating on the theory that markets are at least weak form efficient. In short, I’m saying that SLV going up or down yesterday has absolutely no bearing on how it will perform today. Most investors and all economists (that I know of) have accepted weak form efficiency in the U.S. stock market.

Is the price of silver going up or down? Long term, it goes up. Inflation makes this virtually certainty, however the increase could be less than inflation so even long term investors could lose wealth. Short term, it will do some of both. However, I don’t think SLV should be treated as a typical investment. It does not pay dividends. It does not pay interest. The only reason for a retail investor to hold SLV (outside of speculation) is to take advantage of Modern Portfolio Theory.

Let’s talk standard deviation of daily returns

I’m going to be using four funds to make my case. Those four funds are listed below:

The following chart contains the standard deviation of returns on a daily basis:

So if you were only holding one asset in your portfolio, SLV would be a very dangerous asset. The standard deviation of returns is indicating that there are several dramatic changes in the price of the security. However, many investors are considering SLV as part of a more diversified portfolio. To better understand the risk that SLV adds to a portfolio, I’ll be using several ANOVA tables as I did some regression analysis.

I’ve mentioned on occasion that I don’t believe that the S&P 500 should be considered a proxy for the market of all investable securities. There hasn’t been a great deal of convincing research published in that respect, but I will fix that soon.

Some people objecting to using the S&P 500 feel that the Russell 3000 is a viable replacement. I think they are right to add more securities to the index, but I don’t think the Russell 3000 provides enough diversification because there are still common risk factors. I’ll use some charts and tables to show what I mean.

I’m starting with a regression analysis using the dividend adjusted daily close values of IWV and SPY .

The correlation is over 99%. In short, the IWV and SPY funds perform about the same. For people that are new to statistics, a picture can really drive home that point.

The blue line is the Russell 3000 and the green line is the S&P 500. I think those lines are pretty similar. Therefore, I don’t think the difference between using the Russell 3000 and the S&P 500 is really important. If investors really want diversification, simply using IWV instead of SPY won’t deliver that diversification. Because these indexes are roughly equal, I will simply use SPY for the rest of the article.

SLV is not easily explained by SPY. I’ve prepared a regression analysis on this combination as well.

Here the correlation is just under 25%. In terms of correlations, that is fairly low. The low correlation allows us to add SLV to a portfolio of SPY and have a lower standard deviation of daily returns even though SLV is riskier than SPY when they are considered in a vacuum.

I tested several portfolio combinations of SPY and SLV to find the smallest standard deviation of daily returns to the portfolio. The following chart compares the deviations for SLV, SPY, and the portfolio.

In this portfolio the allocation is 88% to SPY and 12% to SLV. If the percentage of SLV goes either up or down, the portfolio’s standard deviation increased when measured over the time period I used.

Does that mean 12% SLV is ideal from a statistical standpoint?

In my opinion, 12% is about the highest exposure any investor can rationally argue for. Silver does have the potential for very dramatic appreciation within single years and the potential for that appreciation can be very appealing. However, in the long term I believe the security should only be used to improve the stability of the portfolio. In the short term, I do not believe in confusing speculation with investing. Therefore, I would consider dramatic changes in the short term composition of the portfolio to be attempts at market timing.

Do precious metals move together?

There is a strong correlation between SLV and GLD. though SLV is the riskier of the two securities. The following ANOVA table shows the regression results on SLV and GLD.

The correlation of over 80% is fairly strong and indicates that a substantial portion of the movements in silver are tied to the movements in GLD. The importance of having exposure to silver in your portfolio is substantially lower if your portfolio already contains significant exposure to gold.

What is the required return on SLV?

It really depends on who you ask. Different analysts will use very different risk free rates and market risk premiums. The risk free rate could be quoted as the yield on a one year treasury security, a ten year security, or the average yield over the last ten or twenty years. There are legitimate cases to be made for any of these options. The same can be said about applying the market risk premium. However, there is one thing that I believe most analysts will agree on.

The required return should be related to beta. If you ask Yahoo Finance for the beta of SLV, the answer is 1.67, as shown here.

However, when I calculated the Beta using nearly 5 years of data, I came to a beta of only .51. When I modified my strategy to use the last 3 years (10/17/2011 to 10/17/2014) I reached a beta of .65. Yahoo may use other statistical controls or use weekly, monthly, or annual time periods.

Conclusion

Investors should consider their risk and return objectives in the context of the entire portfolio. Based on my research, I believe SLV can be used to lower the risk in a portfolio despite the very high volatility of silver prices.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.