Aug 052015

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]”.