As many investors know, gold is a “safe-haven” asset that can actually increase in value during stock market crisis and times of uncertainty. In an environment of fear, high oil/ energy prices gold seems to be a natural destination for investors. Gold as a quasi currency, given its quoted in US dollars and primarily bought by non-dollar domiciled individuals like those in India and China, tend to appreciate when US dollar falls. But apart from being a safe place to store your wealth like a kind of insurance, are there any other benefits of including gold in your portfolio, together with stocks, bonds, properties and others?
As we show in this article, gold has value as a diversifying asset, and that we should include a percentage of it in our portfolio. Empirical evidence suggests that up to 4-5% of portfolio weight should be gold as it adds diversifying power across the risk spectrum. One of the reasons for this is that gold as an unbiased, representative commodity exhibits very low or negative correlation with other major assets like stocks. There is further evidence to support including gold in your portfolio and that this would be useful for investors with low to medium risk appetites.
The appropriate allocation to gold is dependant on risk level of the portfolio:
• For low risk portfolios: 1-2% of portfolio weightage is significant and useful component,
• For a balanced portfolio (i.e. medium risk), an allocation of 2-4% depending on assumptions would be sensible,
• For high risk portfolio, it is harder to make the case for gold’s inclusion as it is not the asset with the highest long term expected returns. But, including gold may provide stability in poor markets and economic climates which can enhance the compound return of an aggressive strategic portfolio.
In summary, whether you are in a low, medium or high risk category, research has shown that it is important to have some gold in your portfolio as a valuable diversifying asset.
What is diversification?
It is another way of saying” don’t put all your eggs in one basket”. And in terms of your wealth, it means: don’t put all of your money in the same place. Hence, it’s not advisable to have all your money all tied up in stocks and nothing else. In the event of a severe market downturn like in the financial crisis of 2008, all your wealth could be wiped out. Similarly it is not wise to hold all your money in a current or savings account, as the real returns would be dismal and not likely to beat the inflation rate.
Generally, it is argued that the returns from financial assets like stocks, bonds and others display random volatility. That is, the ups and downs are unpredictable, and do not display any particular trends. One of the factors that affect the returns on investments is risk. Therefore, it is important that portfolio risks be reduced through diversification. In Modern Portfolio Theory (MPT), research papers by Markowitz, Modigliani & Miller say that: it is possible to reduce portfolio risk without giving up returns. This is done by broadly diversifying into different asset classes, which are less than perfectly correlated with each other. We can diversify across asset classes, sectors, regions or countries, and styles in order to achieve this diversification.
Diversification, in short, is about getting higher returns per unit of risk taken; this is done by building a well diversified or efficient portfolio.
For an exposition of the mechanics of this, refer to Appendix (“efficient portfolio”).
What is asset allocation?
This is the process of deciding how to distribute your wealth among the different asset classes. There are many different assets that can be included in your portfolio. As you accumulate your wealth thorough savings and investing, you may want to allocate some to certain asset classes; overall the portfolio of assets should help you achieve your financial goals, be it to retire well or to fund your kid’s education.
Strategic role of gold in diversification
It is well known that gold is a valuable tactical asset. It is highly susceptible to geopolitical factors: during times of relative stability, it is useful to keep a small allocation of physical gold in your portfolio. During times of prosperity in the stock market, the yellow metal may not perform as well as non-physical investments such as stocks, and generally may under-perform. But during periods of extreme pessimism, and financial crisis, gold tend to do extremely well: for example during 2008, gold broke $850/oz as the sub-prime crisis unfolded and it promptly marched past $1000/oz. In 1980’s gold rose to its heady heights on combination of inflationary fears, the oil price and Russians invading Afghanistan. Silver was even more rampant – hitting its high of $49/oz in nominal terms during this period.
With the exception of commodities, gold is not a substitute for other assets. As such it may pay to replace the allocation to commodities (empirical evidence^ suggests up to 4-5% of portfolio weight ) with gold as it adds diversifying power across the risk spectrum. One of the reasons for this is that gold as an unbiased, representative commodity exhibits very low or negative correlation with other major assets like stocks. In other words, if the Dow Jones Industrial Index (DJIA) were to take a spectacular tumble, the likelihood of gold doing the same is relatively low. More likely than not, gold price may even move up as uncertainty/shock in the stock markets, may drive up the fear index, hence, some significant money could flow into gold holdings instead.
In the report “Gold as a Strategic Asset for UK Investors” by Rozanna Wozniak, World Gold Council, 2008, suggests that over the long run, gold competes on the basis of its diversification qualities rather than returns. And that “a strategic allocation to gold is nevertheless optimal and this allocation is statistically significant for low to medium risk investors”. In other words, there is evidence to support including gold in your portfolio and that this would be useful for investors with low to medium risk appetites.
The appropriate allocation to gold is dependant on risk level of the portfolio:
• Empirical findings by NFA show that a small allocation to gold, in order of 1-2% is significant and useful component of a low risk portfolio,
• While gold is sensible in a balanced portfolio (i.e. medium risk) in the order of 2-4% depending on assumptions.
• For high risk portfolio, the report finds that its harder to make the case for gold’s inclusion as its not the asset with the highest long term expected returns, However, they found that gold may provide stability in poor markets and economic climates which can enhance the compound return of aggressive strategic portfolio.
In short, it is important to hold some gold in your portfolio – whether you are in a low, medium or high risk category, as the value of gold as a diversifying asset is well documented.
**
“When we have gold we are in fear, when we have none we are in danger”
- English proverb.
Chris Gan
21 Sept 2010
Appendix
The aim of diversification is to build an efficient portfolio
– Assume normal distribution & using expected return, standard deviation, and covariance to develop this,
– By combining different assets with different return/risks.
By shifting the efficient frontier i.e. from B to A – we get the same risk but with higher returns. Key: Is to add less than perfectly correlated assets to portfolio. Diversification is the only “free lunch” in finance (same price but more value).
^Gold as Strategic Asset, New Frontiers Advisors LLC, World Gold Council, Sept 2006
