What Role Should Gold Play In Today’s Portfolios?
To some people, suggesting that gold should be part of a balanced investment portfolio is like suggesting leeches are a way to cure ailments. Many investment advisors consider gold to be a ‘barbarous relic’ that has no place in today’s modern portfolio, given our current financial innovations and instruments.
Yet when examined carefully, it is clear that gold is another asset that has the potential to add non-correlated returns to a portfolio. In this manner, it actually fits very well with modern portfolio theory, and gold should be incorporated by all investors and responsible financial advisors.
Why gold gets a bad rap as an investment
One of the biggest misunderstandings about gold as an investment is an unfair comparison to other financial assets. Gold is not an ‘investment’ in the sense that it brings the expectation of a positive return or cash flow, like stocks or bonds that pay interest or dividends.
An ounce of gold in your portfolio today will be an ounce of gold 100 years from now. It will not magically grow, expand or compound. It will not pay anything in return, and will likely cost a very small amount in storage fees or insurance. This is why gold is sometimes referred to as a non-productive financial asset.
As a financial asset, it is also criticized as something that only keeps up with inflation over the long-term, usually underperforming stocks and bonds, while exhibiting price volatility. But this is unfair and a misrepresentation of the essence of gold and the purpose it serves in a portfolio. Gold should never be considered as a stand-alone investment, but always as a part of a portfolio.
How to evaluate gold
The main function of gold is to protect purchasing power, both locally in terms of inflation as well as globally in terms of currency fluctuations, and to mitigate risk. Gold performs well in times of stress or domestic/international crisis, as well as serving as one of the most liquid of all assets and commodities.
In other words, it doesn’t make sense to evaluate something based on criteria that do not apply. After all, you wouldn’t evaluate a bus by how fast it can go and then compare it to a Ferrari. A bus is not designed for speed and high performance, but for transporting a large number of people.
Similarly, some people inappropriately evaluate the nominal returns on gold and compare this to the performance of stocks. But the purpose of holding gold is not capital appreciation, but capital preservation.
Those familiar with modern portfolio theory understand that the holy grail of investing and asset allocation is to obtain more return and less risk. An asset will be added to a portfolio if it can significantly reduce risk without giving up much in terms of return. This is akin to the concept of correlation, or how much two assets move together: either in step with each other (correlated) or out of step (non-correlated).
Physical gold has either very low correlation or even negative correlation to almost all other asset classes, including stocks, bonds, cash, real estate and even other commodities. Therefore, even though gold can be quite volatile in price, those swings are usually going the opposite way of other major asset classes like stocks.
In a white paper, Merk Investments ran a few portfolio simulations that reverse-engineered the proper amount of gold. In other words, the study found what percentage of a portfolio should be invested in physical gold in order to achieve the highest return for a given amount of risk, something financial practitioners refer to as the efficient frontier.
The study found that from 1971 through February of 2014, a whopping 29% allocation to gold would have achieved the best risk-reward profile for a portfolio, compared to 100% in stocks; this, despite gold being more volatile than stocks during this period.
To be clear, the study does not state this as investment advice; it is simply finding the percentage number that fits the historical data. However, the study clearly drives home the point that a surprisingly high percentage allocation to physical gold would actually improve the risk-reward balance of a portfolio.
Of course, portfolios are not merely divided between stocks and gold. Other non-correlated assets can also be added, such as real estate or other commodities. Previous studies over the years have found that a 5-15% allocation to physical gold is therefore reasonable.
Here at Anthem Vault, we believe a reasonable allocation to gold is 10-20% of your investment portfolio, depending on your level of risk acceptance and other factors. Contrary to the opinion of some, and in-line with historical data and modern portfolio theory, this allocation can greatly lower your portfolio’s risk without sacrificing returns.