Should You Incorporate Gold / Precious Metals in to Your Asset Allocation?

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About a year ago, I spent a good bit of time analyzing the Permanent Portfolio concept created by Harry Browne in the 1980’s, both in a post on my own site and also a guest post for Flexo on Consumerism Commentary.

If you’re not familiar with the Permanent Portfolio that Harry Browne popularized in his book, Fail Safe Investing, it is a passively managed asset allocation strategy constructed by components in such a way that at least one component is favored by any of the possible broad economic movements. The Portfolio components are as follows: 25% in stocks, which do well in times of prosperity, 25% in gold, which does well in times of inflation, 25% in bonds, which increase in price during times of deflation, 25% in cash, which does well in times of tight money/recession when interest rates rise.

For the most part, I have covered 3 out of 4 of the Permanent Portfolio components pretty completely on my site. However, the one remaining (and fairly fascinating) component that I haven’t really dissected all that much is the gold / precious metals component.  

As such, the purpose of today’s post will be to examine the in’s and out’s of how to decide if adding a gold / precious metals mutual fund to your asset allocation is appropriate.

Let’s get started!

What Does the Literature Say? – Adding Gold / Precious Metals to Your Portfolio

As is my tradition here when I analyze asset allocation, I always like to provide a summary of what the asset allocation experts think before launching in to my own investigation. As such, listed below is a summary of the opinions of several of my favorite asset allocation authors on whether or not the gold/precious metals asset class should be added to investors’ portfolios.

Indeed, one of the things that makes precious metals so fascinating is the amount of disagreement and controversy that exists between experts as to whether it is a worthwhile investment.

• Larry Swedroe (probably my favorite investing author I have found to date)
• In his newer 2010 book, The Only Guide You’ll Ever Need for the Right Financial Plan, Larry recommends that investors NOT hold gold/precious metals because 
• 1) It has very high volatility, 
• 2) May or may NOT deliver returns that compensate for the increased volatility, and 
• 3) May or may NOT hedge against inflation effectively.
• Burton Malkiel
• In his famous and amazing book (2003 edition), A Random Walk Down Wall Street, Malkiel mentions that he used to be very negative about holding gold as an investment, but since 2002, has changed his mind slightly. 
• He believes that gold/precious metals should not make up a huge portion of one’s asset allocation, but that a small amount (5% or less) can help diversify a portfolio.
• William Bernstein (my 2nd favorite investing author I have found to date)
• In his 2002 book, The Four Pillars of Investing, Bernstein recommends that even though precious metals have had extremely low long term returns and are extremely volatile, they should be included in small amount (2-3% or less) in one’s portfolio, provided that the investor is comfortable with them. 
• This is due to the fact that they are 1) almost perfectly uncorrelated with other asset classes, 2) will be profitable during high inflation, and 3) the high volatility will allow for a rebalancing benefit. 
• This perspective was approximately echoed in his 2001 book, The Intelligent Asset Allocator, as well.
• Rick Ferri
• In his 2006 book, All About Asset Allocation, Rick recommends that investors AVOID gold/precious metal funds because even though they have low correlations with other asset classes, they also have very low returns, causing it to not be worth the volatility.

So, as we might have expected, there is a lot of disagreement among the experts about whether it’s worth it for investors to hold precious metals. In fact, we have a 1/2 split among the authors above. Awesome!

However, there is ALWAYS agreement about 3 things – precious metals are..

• 1) Volatile and feature low correlation with other asset classes, 
• 2) Not likely to produce good returns, and most importantly,
• 3) Should ONLY be invested in by investors that are comfortable sticking with them for long periods of time. And if this criteria is met, precious metals should only constitute 3% or less of an investor’s portfolio.

Gold and Precious Metals in a 1-Component Portfolio, 1972-2011

As usual, the first thing that I like to look at when analyzing an asset class for portfolio design is how it has performed by itself over a fairly long time period.

To do this, I again utilized the Boglehead.org forums Simba back testing data to analyze the performance of a $10,000 initial investment in gold and precious metals from 1972-2011 (data for precious metals is only available back to 1985, so I used gold as stand-in proxy for precious metals during the 1972-1984 time period).

The results of the back test can be seen on the graph below for the 1972-2011 time period, where the green line and purple lines represent gold and precious metals, respectively. I also modeled the same $10,000 initial investment in the Total US Stock Market Index (blue line) and Short-Term Treasuries (red line) during the same time period.

Looking at this graph, there are several interesting observations that can be made:

• Gold and especially precious metals have performed extremely strongly over the past 40 years! 
• Just take a look at the (purple) precious metals plot. That asset class has outperformed the US stock market by a huge margin during the past 40 years.
• Of course, this is likely the whole reason why there has been so much “buzz” swirling in the investment community about gold and precious metals over the past few years. 
• However, this is also fairly alarming/concerning to me because the long-term analyses from nearly every author mentioned above came to the conclusion that precious metals do not actually deliver high / good returns.
• This graph also very nicely shows how volatile precious metals can be! 
• For example, in 2008, precious metals lost 56% of its value, whereas the total US stock market only decreased 37%. Now that’s what I call one volatile asset class, eh?!

Shown below are the detailed return numbers from 1972-2011 that go along with the 1-component graph/analysis above. As expected from what was reported in the literature, both the gold and precious metals asset classes displayed much higher standard deviations of annual returns than the overall stock market (in fact, between 1.5-2x more!).

Along with the high standard deviation, I also wanted to point out two other things that this data shows us. First, as was hinted to by the performance graph above, precious metals have delivered higher overall average returns than the US stock market between 1972-2011 (green highlighted cell above). However, the asset class was NOT very efficient at all at giving this high return, featuring the low ratio of return to risk of 0.42.

In plain English, this means that precious metals did not compensate investors as efficiently as the total stock market (or other higher risk/higher return emerging market / small cap value portfolio components often used to increase returns shown in the table below) for the amount of risk they shouldered.

Gold and Precious Metals in a 1-Component Portfolio, 1972-2002

To me, the results from the analysis above examining the 1972-2011 time period were quite surprising (and also made me a little skeptical).

During my research of the Permanent Portfolio, I encountered many warnings stating that investors should be skeptical of the superior recent performance of the Permanent Portfolio because long term bonds and gold/precious metals had performed at higher-than-historical levels of the past 10 years.

Taking this warning in to consideration, I decided to re-run my back testing analysis, starting with the year 1972, but chopping off the last 10 years or so from 2002-onward (please note that 2002 was the year in the graph above when the precious metals class really “took off” and started to outperform the overall stock market).

The table below displays the back testing return data results from the “shortened” 30 year period from 1972-2002. As can be clearly seen (red highlighted cells), the superior performance of gold and precious metals over the total US stock market sort of breaks down when the “Lost Decade for Investors” is excluded. In fact, precious metal average returns are about on par with the almost-risk-free Short-Term Treasuries, but feature 6x more risk. Regarding the return/risk ratio, precious metals are even less efficient in this 30 year period (only about half the efficiency of the total US stock market).

Correlations of Annual Returns – Gold / Precious Metals vs. Other Asset Classes

One of the few things that asset allocation experts definitely agree on regarding precious metals is that one benefit they do offer is a diversification benefit because of low correlation with other asset classes.

To provide some concrete numbers to this statement, I generated the correlation coefficient matrix below for the annual return data of gold, precious metals, short-term treasuries, and the total US stock market.

As you can see in the table above, the literature sure wasn’t lying when they said that there is a correlation benefit!

For example, precious metals only move in the same direction as….

• The total US stock market 24% of the time, and
• Short-Term Treasuries -19% of the time, meaning that they move in opposite directions!

Conclusions from 1-Component Portfolio Analysis of Precious Metals and Gold

Overall, the 1-component portfolio analysis above shows us that gold/precious metals..

• 1) Should technically provide us with a diversification benefit in our portfolio due to the favorable (low correlations), and 
• 2) Should not be counted on to compensate us with sufficient returns to pay us for the large volatility they require us to shoulder.

Does Incorporating Precious Metals / Gold in to a Diversified Portfolio of Stocks and Bonds Improve Performance?

While examining the precious metals and gold asset classes in the isolation of 1-component portfolio is fairly interesting and provides some level of insight in what we can expect, it has not enabled us to draw a concrete conclusion as to whether adding this risky asset to our portfolio is worthwhile.

To try to find an answer, we need to look at how precious metals would perform if/when incorporated as part of a diversified portfolio.

To do this, I modeled a portfolio utilizing a set fixed income asset allocation of 30% (in short-term treasuries), and then filled the rest of the portfolio with a mix of precious metals (0-50% of the total portfolio value) and the total US stock market index asset classes.

The results of this analysis can be observed nicely on the graph below of average annual return (y-axis) vs. standard deviation/risk (x-axis). There are two plots – one for the 1972-2011 time period (blue line) and one for the 1972-2002 time period (red line).

Let’s start at the bottom of the plots, where the first point represents a portfolio containing 0% precious metals. As we add 0-20% allocations of precious metals, we see something “magic” happen – portfolio risk decreases, but portfolio return increases! Nice, right?! So, adding precious metals over the past 40 years definitely would have increased portfolio performance!

If you dig through the detailed numbers, you see that the maximum efficiency (highest ratio of return to risk) occurs around an 18% portfolio allocation to precious metals.

Surprisingly enough, the ~18% allocation level to precious metals was found to be the most efficient level for both time periods, despite the lower performance of precious metals when the analysis was stopped at 2002. It is also fairly interesting to note that this level almost aligns with the Permanent Portfolio allocation to precious metals, which was 25%! Crazy uh?

Reality Check – Is it “Worth It” to Add Precious Metals / Gold to Your Portfolio in a Small Amount?

In the section above, we see that there is clearly a significant benefit to adding a large amount of precious metals to your portfolio over the past 40 years.

However, there is a problem with this – one that I mentioned was stopping me from adopting the Permanent Portfolio fully. The problem is that holding the optimal ~20% allocation to precious metals would cause most, if not all, investors to have tracking error in their portfolio (in other words, lose discipline to their set strategy and change their allocation). 

Because of this, I am going to say that unfortunately, the level that was found to be mathematically optimal in the modeling above does not work in the real world.

Having established this belief, the questions then become, 1) “If it is clear that adding precious metals to a portfolio improves performance, how much is a realistic amount to add? 2) And, with this realistic amount, is the increase in performance worth the trouble of holding this sometimes “pesky” asset class?”

Let’s explore the first question – how much of an allocation to precious metals is realistic. For me, given the varying opinions about precious metals among experts in the literature and the fact that it isn’t a very efficient and/or reliable asset class, I would say that 3% is a good maximum allocation I would be able to give to precious metals.

Having established this realistic allocation level, we can then explore how much, if any, benefit the small addition would give us in a diversified portfolio.

To do, this we need to dig in to the precise return numbers utilized in building the risk/return curves in the previous section, specifically focusing on the less than 5% precious metals allocation. The two tables below show the resulting data from this analysis, one table for the 1972-2011 period and the other for the 1972-2002 period.

If we look at the 1972-2011 period, we see that the “mathematically” optimal precious metals allocation of 20% gives us an extra 1.2% annual return on average. However, if we utilize the more “realistic” precious metals allocation of 3%, we only receive an extra 0.18% return each year. If we equate this increase in annual return to ending portfolio value, we would have 9.4% more money at the end of the 40 year period by holding 3% of our portfolio in precious metals.

If we examine the 30 year period ending in 2002, the case for holding a small amount of precious metals becomes somewhat less compelling. When we move from having no precious metals to a paltry 3% allocation in precious metals, we only receive 0.11% more in per year average return. If we again equate this increase in annual return to ending portfolio value, we would have 5.3% more money at the end of the 40 year period by holding 3% of our portfolio in precious metals.

So, by having a realistically small amount of 3% of our portfolio allocation in precious metals, we can increase our portfolio’s ending value by 5-10% over a 40 year period.

The question I ask myself is, “Is this relatively small increase in ending value that we receive by adding a precious metals to our portfolio worth the risk of the tracking error that might be introduced to my portfolio by the addition?”

Conclusion – For me (and for likely the majority of investors), I am going to say that precious metals / gold are not worth adding to your portfolio because it is more likely that holding precious metals will cause you to change your strategy before realizing the tiny benefit that holding precious metals might give you. 

Furthermore, if I wanted to increase returns, I could likely just increase my allocation to an asset with a more trusting risk/return profile, such as emerging markets and/or small cap value stocks.

If you’re interested in viewing all of my calculations from this investigation, click here to view the Google Docs Spreadsheet.

Should You Incorporate Gold / Precious Metals in to Your Asset Allocation? is a post from: My Personal Finance Journey