Gold had another good year in 2019, returning +17.4% in USD terms. Since bottoming at the end of 2015, gold has put together an impressive four year track record, returning 40.8% since 12/31/15 or about 8.9% annualized. Given that inflation has begun to turn up in the last few months as well, it’s unsurprising that investors are taking a fresh look at the “barbarous relic” and asking “Should I have an allocation to gold in my portfolio?”
Gold (along with the rest of the precious metals complex) is a unique asset class. It produces no cash flow, making it difficult to calculate an intrinsic value. It is prized for both jewelry and industrial uses, and shares some properties with other commodities, but is not “consumed” like oil or agricultural products. It is also considered by many to be a form of money itself, although rarely used for that function since paper or electronic money is far more convenient. Many investors buy gold as an inflation hedge, although it serves that function rather poorly as its correlation with the US dollar swings wildly between positive and negative. In other words, there are many periods in which inflation is high but gold declines in value. Notably, there are far better alternatives if “inflation-protection” is the primary goal.
However, since President Nixon closed the gold window in 1971, rendering the USD a pure fiat currency, gold as an investment has performed well, returning about 7.6% per year and handily exceeding the 4% rate of inflation since then. The issue with including gold in your portfolio is not the return per se, but rather, the volatility. While gold has performed similarly to intermediate-term Treasury bonds (+7.0% annualized) since 1971, that performance came with a volatility (risk) measure more than three times greater. For this reason, no competent adviser would recommend a portfolio of “100% pure gold”, because the result would be very inefficient (lots of risk relative to the expected return).
But gold does have one very attractive property – a near zero correlation with the US stock market. This makes gold useful as a potential diversifier, especially for a traditional portfolio of stocks and bonds. Let’s see how this might work in practice-
Using the free online tool Portfolio Visualizer, I constructed three portfolios for comparison purposes; a “traditional” 60% US stock / 40% Intermediate-term US Treasury bond portfolio, a 55/35/10 allocation (US stocks / US T-bonds / gold) and a 50/30/20 (stocks / bonds / gold) portfolio. The data covers the 48 year period from January 1972 to January 2020 and the results are in the table below:
55% US Stocks
50% US Stocks
60% US Stocks
The figures for portfolio 2 and 3 are compelling – adding a 10% allocation to gold improved both the risk and return characteristics of the 60/40 portfolio, and raising the gold allocation to 20% improved the outcome even more. Compared to a traditional 60/40 portfolio, a 50/30/20 portfolio had an annual return that was .32% higher with a 0.5% reduction in standard deviation (risk). It also improved the “worst year” and “maximum drawdown” categories, protecting the portfolio somewhat from severe losses in the stock market. (It’s important to note that beyond an allocation of about 20% to gold, the portfolio’s overall risk / return profile began to worsen.)
These results may seem counter intuitive, since gold is not a particularly attractive investment by itself. But this is a great example of the power of diversification – by combining assets with low correlation to each other, one can raise the overall efficiency (risk / reward balance) of a standard stock / bond portfolio. This desirable effect can also be obtained by combining bonds with stocks, foreign stocks with US stocks, real estate with stocks (and bonds), ‘value’ stocks with ‘growth’ stocks, and small stocks with large stocks. The key takeaway is that while adding a small allocation to gold might improve your portfolio somewhat, the most ‘optimal’ portfolios contain several of these asset classes working in concert to achieve the highest return possible for an acceptable level of risk.