Axel G. Merk | Dec 11, 2013 03:22AM ET
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 “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:
Before looking at these charts, keep in mind:
Stocks & Gold: 5-Year Efficient Frontier
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
Now, let’s go back almost 80 years:
Stocks & Gold: Efficient Frontier Since 1934
Gold in a Balanced “60/40” Portfolio: 5-Year Efficient Frontier
With this context provided, let’s look again at the past 5 years, but this time, adding bonds into the mix. We assume a static 60/40 ratio of stocks to bonds, often referred to as a “Balanced Portfolio,” then add the “optimal” amount of gold to the mix – again using hindsight:
What correlation?
To find an Optimal Portfolio, it’s important how the underlying securities in the portfolio interact with one another. But that’s not so trivial, as correlations across securities and asset classes are not stable. To illustrate the point, most have heard that the U.S. dollar benefits from a “flight to safety.” That may have been the case for a little over two years up to the summer of 2012, but ever since then, the “risk on” / “risk off” trade became more complicated. Or when money fled emerging market local debt where investors thought they could have a free lunch picking up yield with little risk, such money didn’t go into the U.S. dollar, but started to chase yields in government bonds of weaker Eurozone countries. Or take gold: there are periods it moves in tandem with the stock market, others where it moves in the opposite direction. Indeed, there are periods when gold has been a hedge against a falling stock market; but it’s not always inversely correlated with the stock market. Gold may also thrive in a rising interest rate environment, as it did in the late 1970s.
Here’s a selection of other alternative investments and how they correlate to both equities and bonds:(*)
What return?
The theory works best when we plug in “expected” returns. Wouldn’t it be great if we knew tomorrow’s return? In practice, many investors use historical returns. As you might imagine, these models heavily favors assets that had a good return during the given look-back period – so don’t think the result is unbiased simply because you let a computer generate results. Indeed, one of the biggest challenges in presenting Optimal Portfolios is that they are heavily influenced by the underlying assumptions. Someone can show you that a given investment would have made a fantastic addition to your portfolio, but you may want to look more closely whether the assumptions are realistic going forward.
What risk?
Just as returns play a role, so does risk. In finance, a lot of investors employ standard deviation of returns as a measure of risk. Yet many investors are just fine with “upside risk,” but do have a problem with “downside risk” (there’s a measure for that, the Sortino ratio). Maybe just as relevant, these models are not very good at capturing high risk, low probability events, also called market crashes. In other words, an optimization analysis that uses historical returns may understate risk if the time period used does not capture a market crash in that given asset. Further, many measures of risk are relative to a benchmark “risk free” rate; but in today’s world, one might argue that there’s no such thing as a risk free investment in an environment with negative real interest rates given that one’s purchasing power is at risk no matter what one does.
Optimal Portfolio: Really?
The takeaway from this exercise may be to look at alternatives in general as a supplement to a traditional equity and bond portfolio. Investors may want to take a pro-active approach to learn how to add value to a portfolio, keeping an open mind about the risks and opportunities out there, especially after the run-up the stock market has had.
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