How Much Gold?

 In Market and Investment Insights

How much gold should an investor hold in a well-diversified portfolio? Too small an allocation and even a large price jump won’t make an impact. But too large an allocation is a portfolio drag as the dead money provides no growth and no cash flow.

There are four reasons to hold gold – it can keep up with inflation, especially over the long run, generally rises when equities are falling, can hedge local currency risk, and you can trade it for food and guns when the system collapses.

We can’t handicap the end of the world, but bad things do happen occasionally – stock markets fall, currencies get devalued, and bank depositors suffer haircuts. Gold and sovereign bonds are typically the only two assets that benefit from chaos. So there is some diversification value in holding gold to reduce portfolio losses especially if a country’s stocks and bonds are both dropping.

Since the gold standard ended in August 1971 through to August 2017, there have been 19 corrections in the US S&P 500 index (defined as a decline of 10% or more). US government bonds have historically been a decent hedge – the 10-year Treasury has averaged a +6.5% total return during these drawdowns. Gold has also done well rising 9.5% on average.

So what is the “best mix” of Treasuries and gold during these S&P 500 corrections? Let us analyze for effectiveness (i.e. did the hedge make money) and dispersion (lowest variability of outcomes). The chart below shows the success rate (return greater than zero) and Sharpe ratio for adding 0%-20% allocation of gold to a portfolio where the only other asset is a 10-year Treasury bond.

The hypothetical portfolios show how various combinations of bonds/gold would have performed during each of the 19 correction periods. Success is defined as a positive return (the grey line) i.e. a 90% bond / 10% gold portfolio rose during 16 out of 19 equity corrections (84% success). The Sharpe ratio (the red line) is based on the returns/volatility over all 19 correction periods – higher Sharpe indicates a more consistent hedge.

Allocation of Gold in Hedge Portfolio (%)

Source: Morningstar, Bloomberg, Janus Henderson, September 2017

The graph shows that both the success rate and Sharpe ratio were highest around a 10% allocation to gold. However, it is worth noting that even the best combination had an 84% success rate during stock market downturns – the hedge is not infallible. There have been rare occasions where stocks, bonds and gold all dropped in unison. Still, pairing up bonds and gold has often resulted in a better hedge against stocks falling than bonds alone.

Notably the above analysis is from the perspective of a U.S.-only investor. However, non-U.S. investors may also benefit from an allocation to gold. It is often a convenient way to allocate some of their portfolio into U.S. dollars, especially as their local currency government bonds are less likely to rise during times of crisis. Gold is also more attractive in countries with either high inflation or negative cash interest rates.

A completely different approach is to take a leaf from the passive playbook to allocate gold via market capitalization weights. The World Gold Council estimates the above-ground stock of gold globally is about 187,000 tonnes (6 billion troy ounces) which is currently worth around US $8 trillion. The market capitalization of all stocks in the world is circa $80 trillion. Size estimates for the global bond market vary widely but most are between $50 and $100 trillion. Taking the midpoint shows a similar result – gold is about 10% of bonds or about 5% of stocks and bonds combined.

Neither method “proves” that you should definitely hold a certain percentage of gold – but starting points for thinking about allocation within a portfolio. More recently bitcoin has been cited as a “hedge,” but its current market capitalization of around $75 billion is about the same as Starbucks. Although that is an argument for bitcoin’s potential, for now it is too small for most investors to use as a diversifier. Gold and cockroaches will likely survive the apocalypse, but it is doubtful that bitcoin will.

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Sharpe Ratio measures risk-adjusted performance using excess returns versus the “risk-free” rate and the volatility of those returns. A higher ratio means better return per unit of risk.
Hypothetical examples are for illustrative purposes only and do not represent an actual investment.