The role of gold in a portfolio


Investment risk and expected investment returns are related. A long-term investor should therefore embrace risk in order to receive the expected return that they demand as compensation for taking investment risk. Intuitively, by seeking to avoid risk, an investor reduces their expected return.

Gold is a form of financial insurance within a portfolio. It is a refuge from risk and should therefore be used in a portfolio to reduce the exposure to equity risk in order to match an investor’s risk capacity. By this reasoning, Gold is not an investment in its own right. It does not add to a portfolio’s expected return, it simply reduces portfolio risk.

Graph of the performance of gold relative to major asset classes since September 2008


To support this reasoning, we recently asked a question of noted finance professors Eugene F Fama at the University of Chicago and Kenneth French of Dartmouth College, their answer to our question is as follows:

GoldCore Question: "Based on spot price data from January 1970 through February 2010, the average return on gold bullion was almost exactly the same as the S&P 500 at 88 basis points per month. Volatility was significantly greater for gold, but since gold prices tended to zig when equity prices zagged over this period, a portfolio composed of 80% stocks and 20% gold (rebalanced annually) had lower volatility than either of its component parts. Doesn't portfolio theory suggest that gold can make a useful contribution?"

EFF/KRF: The answer to your question is "yes" — if you judge that the past average return on gold is the best estimate of its future expected return. We don't buy this, for two reasons. First, much of the stock of gold is in the form of jewelry and other goods that pay a "consumption dividend." This dividend increases the current price of gold and lowers its expected capital gain return. But an investor who holds gold bullion as a portfolio asset only expects to get the expected capital gain, which does not suffice to compensate for the risk of the asset. Second, if the capital gain return on gold is uncorrelated or even negatively correlated with the returns on other assets like stocks, then portfolio theory and its asset pricing offspring imply that the expected return on gold is low because of its role in reducing portfolio risk. Both arguments point to the conclusion that the past average return on gold probably overestimates its expected return.

To summarize, gold makes sense as a portfolio asset only for investors who also get the consumption dividend from gold, since this "dividend" lower gold's expected capital gain. Thus, for investors who do not value the consumption dividend, the expected return on gold does not cover its risk as a portfolio asset, (which takes account of its value for portfolio diversification).
 

However, our reasoning is further supported by an empirical study; Stocks for the Long Run by Jeremy Siegel from which the following table is derived which illustrates the "real" returns from Stocks, Bonds and Gold net of inflation.

Clearly, during the period in which Stocks had their worst performance, Gold performed particularly well in real terms and this notion is explored further in the following study which looks at the performance of Gold since 1960 from the perspective of an investor in Sterling.


We have also examined the performance of Gold using the London PM Fix of the spot price of Gold at the end of the month in US$ over the period January 1971 to September 2009 and this analysis may go some way to dispelling some of the myths associated with Gold as an investible asset class over the long term.


The next analysis  compares the spot price of gold with the Market Vectors Gold Miners Exchange Traded Fund which illustrates clearly that a Gold Mining Fund is not the same as an investment in physical gold with volatility of more than twice that of the price of gold over the period 1998 to 2009.





The last analysis looks at US Mining Companies since 1926