30%+ Gold in a Diversified Portfolio?

Axel Merk, Merk Investments 

December 10th, 2013

How can an investor get guidance on how to construct a portfolio that will protect them should the stock market have another losing streak that lasts more than a few days? We discuss this question while specifically looking at how much gold an investor may want to hold in a portfolio.

In 1934, the price of gold was $35 an ounce; as of September 30, 2013, it was $1,331, yielding an average return of about 5%? Gold bugs might argue this suggests gold should have a permanent place in investors’ portfolios. Conversely, however, those thinking the yellow metal is a barbarous relic, may only see themselves confirmed in their view that gold is overpriced. Keep in mind, the same point can be made about stocks’: historical returns are not “proof” of future returns. Without endorsing either view, let’s have a look at how an investor could have combined gold and equities to enhance risk-adjusted returns.There’s an academic theory, the “Modern Portfolio Theory” that presents an “Efficient Frontier,” an investment mix that maximizes expected returns for a given amount of expected risk. An “Optimal Portfolio” provides the highest risk-adjusted return; often defined by professional investors as the portfolio with the highest Sharpe ratio, a measure of return per unit of risk as measured by standard deviation of returns.

At first blush, our analysis may lead one to conclude investors may want to hold 30% or more in gold. However, we should really be asking the opposite question: is it sensible for investors to have up to 70%, possibly more, of their portfolio in stocks?

Merk Insights

Adding Gold in an Optimal Portfolio

Let’s see what an “Optimal Portfolio” containing gold and equities would have looked like over different time horizons:

  • Past 5 years (daily data from September 30, 2008 – September 30, 2013)
  • Since August 1971 (monthly data from July 31, 1971 – September 30, 2013)
  • Since 1934 (monthly data from December 31, 1933 – September 30, 2013)

By going back that far, we had to limit ourselves to a comparison between gold and stocks (using the S&P 500) to reduce data quality issues with bond indices if we wanted to include bonds. We include dividends in equity returns, and consider a “risk free” rate to find the Optimal Portfolio. Also note:

• The S&P 500 Index was only created in 1957, but a composite of the index is available that we believe is a good representation of the preceding years.

• Dividend information is not readily available for all years. As a result, we relied on research of others. Since 1934, the average dividend yield of the S&P 500 has been approximately 3.69%.

While a 5-year horizon appears reasonably long, keep in mind that five years ago, we were right at the peak of the financial crisis. To address this, we also choose August 1971 as a reference point to gauge the long-term performance of gold; it was on August 15, 1971, that President Nixon ended the convertibility of the dollar to gold. While that is truly a long-term horizon, one could argue that the gold price was artificially depressed until then; and, as a result, any return calculated since then might overstate the potential long-term rate of return for gold. To address that criticism, as a third variant, we went all the way back to the beginning of 1934: that year, theGold Reserve Act changed the nominal price of gold from $20.67 per troy ounce to $35.

Before looking at these charts, keep in mind:

  • These are not investment recommendations;
  • These models use perfect hindsight, i.e., suggesting what would have been the Optimal Portfolio given the returns and risks prevalent during the period.
  • The “Optimal Portfolios” are chosen in the beginning of the period and never rebalanced. In a future analysis, we will discuss the impact of periodic rebalancing.

Stocks & Gold: 5-Year Efficient Frontier

The chart above suggests that given a choice between investing in the S&P 500 (.INX) and gold, an investor would have had the best risk-adjusted returns investing 56% in gold and 44% in the S&P 500. Allocating more to equities might have yielded higher returns, but the volatility of returns would have been substantially higher. Does this mean an investor should have more than half of their investable assets in gold? No, among other reasons, because:

  • We don’t know what returns gold and the S&P 500 will provide going forward; and
  • The investment universe is comprised of more than the S&P 500 and gold.
Merk Webinar

One possible conclusion is that adding any uncorrelated asset to the S&P 500 may improve an overall portfolio. But the above chart also suggests that if one’s outlook for gold or the S&P 500 is different from what it has been in the past five years, the “Optimal Portfolio” may look different. Let’s look at a longer-term chart.

Stocks & Gold: Efficient Frontier Since August 1971

Going back to August 1971, the optimal gold allocation drops from 56% to 30%. Mind you, this includes the run-up in 1980, as well as the subsequent 20-year bear market in gold that followed. It’s likely there aren’t many investors that piled up on gold and the S&P back in 1971, then never rebalanced their portfolio. Still, the takeaway should be that diversification with uncorrelated assets matters, as it is possible to substantially lower the volatility of a portfolio by adding an uncorrelated asset. That applies despite the fact that gold was more volatile than the S&P 500 since 1971 (different from the risk profile over the most recent 5 year period where gold was less volatile than the S&P 500).

Now, let’s go back almost 80 years:

Stocks & Gold: Efficient Frontier Since 1934

Allocating 41% to gold since 1934 would have, according to the theory, provided the “optimal” risk adjusted return: by sacrificing just a little in return, the overall volatility of the portfolio could have been substantially lowered. A couple of caveats:

  • There were restrictions on own gold ownership for U.S. persons from 1933 – 1974; the rules were amended over the years; effectively, starting in 1964, U.S. persons were able to at least invest in gold certificates.
  • Until 1971, the price of gold was not free floating; the model, as a result, gives the appearance that gold was less risky (i.e., the dollar price less volatile) than it might have been in a free market. We are talking about hidden risks here not well captured when using historical standard deviation of returns, although the risk was ultimately more to the U.S. dollar that plunged relative to gold once the yellow metal was cut loose in 1971.
  • The above chart shows that the “Optimal Portfolio” is
    1, 23  - View Full Page