Amid a sea of mainstream media gloomy gold gloating, this unemotional
article from Financial Times’ Alphaville blogger
Matthew Klein asking the question how much of your portfolio should be
in gold is worth a read.
The first part discusses the idea that each person’s optimal portfolio
depends upon their unique personal circumstances and risks. For example, if
you have a stable job like a tenured professor, you could afford to
have a more risky portfolio than a casual labourer. Matthew then
asks, so “do you have liabilities [ie risks] that gold can usefully
hedge”?
He notes that gold is a form of cash, just like paper cash, as it doesn’t
earn a return. However, “what makes gold attractive is that, unlike fiat
cash, gold has a strong negative correlation with the level of real interest
rates” making “it a good hedge for those times when your fiat cash
earns less than what it used to in real interest”.
Matthew argues that gold volatility would suggest a “relatively small
weight as a proportion of short-term liquid assets in a neutral portfolio
(less than 5 per cent), although the specific weight should also be affected
by the propensity of your home currency to experience severe bouts of
negative real interest rates”.
The World Gold Council has done numerous studies on the optimal amount of
gold in a portfolio and they also come to the conclusion that investors
should only hold modest amounts of gold (no more than 10%). This is at odds
with the Harry Browne Permanent Portfolio strategy, which contains 25% gold
and, at least for an Australian
implementation of this strategy, produces consistent and low volatility
returns (see chart below, or check out the back tested annual returns here).
Given gold’s negative returns in recent years, it is worth highlighting
Matthew Klein’s observation that “good hedges don’t necessarily have
positive expected returns over time, but they can still be worth having
because they can smooth out your gains and losses on the rest of your holdings”.
As an example, look at the following comparison of three portfolios
starting with an initial balance of $10,000 in 1972 through to 2014, which I
did using this online tool.
You can see here that the inclusion of 5% gold in a traditional 60/40
stocks/bonds portfolio increases returns and reduces the risk and worst year.
The Permanent Portfolio produces a much lower overall portfolio balance, but
note the massive risk reduction, particularly in terms of worst year. For
those with high risk aversion who can’t afford a bad year (for example, those
in retirement who don’t have an investment timeframe over which to
recover the loss), that performance hit may be worth it to avoid the pain of
years where there are massive losses.
The online tool is quite detailed with a number of options, so I’d
suggested playing with it on different asset allocations and timeframes. My
only concern is that it only does annual portfolio rebalances and my gut is
this would probably skew it against gold compared to monthly rebalances.
For those who have really been bashing gold investment recently, I think
this blog post from 2013 speaks to the idea of “unique
personal circumstances and risks” where John Cochrane says that some
think “about gold as an out of the money put option on calamitous social
disruption, including destruction of the entire financial and monetary
system.” In the end, criticising gold is about discounting the need for
this optionality. OK, great, but as John says “you still have to think
why this option is [not] more valuable to you than it is to [goldbugs]”.
