Axel Merk is the President and CIO of Merk Investments, manager of the Merk Funds. An authority on gold and other hard currencies, he is a pioneer in the use of strategic currency investing to seek diversification. Axel Merk is a sought after speaker and author on topics ranging from the economy, gold and currencies to sustainable wealth and personal finance, as well as a regular guest and contributor to the business media around the world.
The Case For Gold
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? In this white paper we discuss this question while specifically looking at the portfolio impact of gold.
In our previous two gold white papers, we discussed key reasons investors typically cite supporting an investment in gold, as well as the benefits that gold provides for portfolio diversification. This white paper focuses on what the optimal portfolio allocation in gold would have been according to Modern Portfolio Theory over several different periods of time.
In 1934, the price of gold was $35 an ounce; as of February 28, 2014, it was $1,326, 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.
Modern Portfolio Theory
One academic theory, the Modern Portfolio Theory, 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.
“Optimal Portfolio provides the highest risk-adjusted return.”
Figure 1 shows a typical way of depicting the Efficient Frontier between stocks and bonds, indicating what the optimal portfolio with the highest Sharpe ratio would be; the particular allocation to stocks and bonds respectively that would yield the best risk-adjusted return. The theory is not without its critics, notably because hindsight is often a key ingredient as to how an Optimal Portfolio is constructed.
Time Horizons Studied
Our paper analyzes what an Optimal Portfolio containing gold and equities would have looked like over three different time horizons:
- Past 10 years (daily data from February, 2004 – February 28, 2014)
- Since August 1971 (monthly data from July 31, 1971 – February 28, 2014)
- Since 1934 (monthly data from December 31, 1933 – February 28, 2014)
While a 10-year horizon appears reasonably long, keep in mind that five years ago, we were right at the peak of the financial crisis; we wanted our time period to be long enough to include “normal” times as well as “crisis.” For a longer historic comparison of over 30 years, we 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: when the Gold Reserve Act changed the nominal price of gold from $20.67 per troy ounce to $35.
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 (INDEXSP:.INX) has been approximately 3.69%.
When studying the results of our analysis and the accompanying figures, please 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.
The 10-Year View
Figure 2 shows the Efficient Frontier between stocks and gold over a 10-year time horizon. We used the S&P 500 Index as a proxy for the stock market. Figure 3 summarizes the allocation to gold and stocks (S&P 500), respectively, that would yield the Optimal Portfolio for the same time frame. These findings suggest that given a choice between investing in the S&P 500 and gold, an investor would have had the best risk-adjusted returns investing 68% in gold and 32% in the S&P 500. Allocating more to equities might have yielded higher returns, but the volatility of returns would have been substantially higher.
“Adding a gold allocation to stock portfolio improved its risk-adjusted return.”
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;
- The investment universe is comprised of more than the S&P 500 and gold.
One possible conclusion is that adding any uncorrelated asset to the S&P 500 may improve an overall portfolio. But the data also suggests that if one’s outlook for gold or the S&P 500 is different from what it has been in the past ten years, the “optimal portfolio” may look different. For a longer time period, please see Figures 4 and 5.
The 30+ Year View Going back to August 1971, the optimal gold allocation drops from 68% to 29%. 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 matter, 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).
“Diversification with uncorrelated assets matters, as it is possible to substantially lower the volatility of a portfolio by adding