Gold And Asset Allocation

My previous attempt at owning gold (through the SPDR Gold Trust) didn’t work out so well. At the time my actions were largely based on emotion and I didn’t take the time to consider the advantages or disadvantages of including this asset in my portfolio. This got me thinking: Does gold actually provide any benefit in a long-term asset allocation strategy?

Inclusion of the precious yellow stuff in investor portfolios is nothing new. Harry Browne’s Permanent Portfolio called for a substantial portion–25%–of one’s portfolio to be allocated to gold as protection against rapid inflation. More recently Ray Dalio’s All-Weather strategy also has an allocation to gold, although considerably less at 7.5%. [1,2]

In order to make any evidence based conclusions some data needs to be involved. Realize that the total return of gold is simply the price change over a given period of time (in other words gold pays no dividends). The London PM fix price, one of the primary standards of pricing gold, is available from the Federal Reserve Economic Data site (FRED) going back to 1968. Data that goes back to 1833 is available from Kitco Metals Inc., a company involved in the sale, storage and refining of precious metals.

One comment on the Kitco data. The prices are only available in the form of an average annual price. However, this isn’t really much of a concern as the price of gold was relatively stable up until the early 1970’s. Supplementing the London PM fix data with that available from Kitco provides a fairly decent history of how the price of this metal has behaved.

Historic Price of Gold

Up until the early 1970’s the only noticeable fluctuation in price occurred in the early 1930’s. President Franklin Roosevelt suspended the US gold standard at this time to inhibit large outflows of bullion from the Federal Reserve. The actions taken by his administration included purchasing gold at increasing prices, which raised the value of gold in dollar terms, and lowered the value of the dollar in terms of gold. [3,4] Consequently the price of gold increased to about $35/ounce, which was solidified through the Bretton Woods System of 1944. [5] Eventually the Nixon administration ended the convertibility of dollars to gold in August 1971–coincidentally this was when the price of gold really started to take off. [6]

One of the primary arguments for including gold in a portfolio is that provides an additional layer of diversification. This has indeed been the case as it has historically had very low correlations not just with stocks, but with Treasuries as well. This low correlation has held up in the “Post Nixon Era” after the dollar was completely removed from the gold standard.

Gold Correlation 1926-2015

Gold Correlation 1972-2015

However, correlation alone is insufficient to justify ownership of any asset. Consider what it has done to an all stock portfolio

Gold and US Stocks 1926-2015

Gold and US Stocks 1972-2015

From 1926 through 2015 owning some gold helped to reduce portfolio volatility, but this came with a cost in the form of reduced returns. The 1972 through 2015 period did show a slight increase in returns with approximately a 30% stake–approximately what the permanent portfolio calls for. In this scenario portfolio returns increased by a little less than 0.40%. Not insignificant, but the expenses associated with owning this asset (transaction costs, expense ratios, etc.) more than likely took a chunk out of that advantage that.

Another pro-gold argument is that it provides a hedge against inflation. That is, during periods of high inflation the price of gold will change accordingly and maintain purchasing power. While great in theory this hasn’t worked out so well in practice. Using Robert Shiller’s inflation data–which goes back to 1871–the correlation between the annual return (price change) of gold and the annual change in inflation has been 0.20. Not exactly high by any standard.

Price of Gold vs. CPI

It’s not just the shorter, one year periods of time that gold bugs have to worry about. Over longer periods of time gold has also failed to provide protection against rising prices. Gold closed out in December of 1981 at $397.50 per ounce. By the end of 2003 it similarly stood at $416.25–a paltry annualized gain of 0.21% over the 22 year period compared to inflation which ticked along at 3.11%. Campbell Harvey and Claude Erb succinctly described the situation in a paper for the Financial Analysts Journal (the paper is available on SSRN and well worth a read)

Gold has been described as an inflation hedge, a “golden constant”, with a long run real return of zero. Yet over 1, 5, 10, 15 and 20 year investment horizons the variation in the nominal and real returns of gold has not been driven by realized inflation. [7]

Period Annualized
Return of Gold
1871-1971 0.75% 1.21%
1971-1981 24.75% 8.62%
1981-2003 0.21% 3.11%
2003-2015 8.10% 2.10%

Prior to 1971 gold behaved in a very benign manner. In the context of our modern, fiat-money-based economy, its behavior has been anything but stable. When it really performed well was during periods of economic distress–primarily the 1970’s and 2000’s. Since 1971 it has demonstrated a tremendous amount of volatility and a failure to match the US stock market return. Pity.

Annualized Asset Performance
Return Std Dev
S&P 500 10.3% 17.7%
Gold 7.5% 28.7%

After reviewing the facts gold doesn’t appear to have much luster. It’s unproductive, highly speculative, and doesn’t live up to it’s billing as protection against inflation. When you begin to look at hard data the pro-gold arguments out there would appear to be more anecdotal than factual.

1. The All Weather Story. Bridgewater Associates, LP.–press/the-all-weather-strategy.aspx.
2. Tony Robbins: Ray Dalio’s “All Weather” Portfolio. November, 2014.
3. Richardson, Gary, Alejandro Komai, and Michael Gou. Roosevelt’s Gold Program. November 22, 2013.
4. Richardson, Gary, Alejandro Komai, and Michael Gou. Gold Reserve Act of 1934. November 22, 2013.
5. Kollen Ghizoni, Sandra. Establishment of the Bretton Woods System. November 22, 2013.
6. Kollen Ghizoni, Sandra. Nixon Ends Convertibility of US Dollars to Gold and Announces Wage/Price Controls. November 22, 2013.
7. Erb, Claude B. and Campbell R. Harvey. The Golden Dilemma. Financial Analysts Journal. vol. 69, no. 4 (July/August 2013) 10-42.

Kitco Gold Price:
London PM Fix Gold Price:
Robert Shiller CPI/Inflation:

What I’m Reading
Mr. Money Mustache’s retirement (sort of) plan
A Dozen Things I’ve Learned from Richard Thaler about Investing (Tren Griffin)
How Can “Smart Beta” Go Horribly Wrong? (Research Affiliates)
Social media can keep you from being ‘The Millionaire Next Door’ (MarketWatch)