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What Portfolio Theory Says About Investing In Gold

Theory Image


Gold Silver Pros would like to welcome  a very special guest to the website. Logan Kane, the owner of North of Sunset Publishing, is an entrepreneur, author, and journalist. He has written High Finance: The Secrets Wall Street Doesn’t Want You to Know (The Millionaire Trader) which is available on Amazon.

He has an educational background in economics and finance. He has owned and managed rental real estate properties in several locations around the US. He is an avid investor, and spends much of his time studying advanced theories on the economy and the markets.

Logan is a very talented young analysts whose insights into the markets are very prescient and timely. He is a very popular contributor to the very well known financial digest for which I also write, Seeking Alpha.  This is a summary of a former article which we have re-posted here with his permission.



Summary

  • Gold is, without a doubt, the most controversial asset class.
  • However, efficient frontier models show that gold wins portfolio allocations for far greater amounts than the naive expectation would be.
  • Gold holds key investment advantages over other commodities. Additionally, gold shows a positive skew in returns, meaning it tends to “melt up” rather than crash to the downside like equities.
  • Central banks and some very smart people hold at least a small portion of their wealth in gold as a hedge. Should you?

Gold (GLD) is by far the most controversial asset class. The yellow metal has always attracted more than its fair share of colorful personalities. Gold is historically the world’s best store of liquid wealth and a defense against potential devaluation of fiat currencies. But is gold still a viable investment? The answer depends on how you’re trying to invest and what your goals are. For many investors, gold is a good choice. A 5-7 percent allocation to gold has been shown to reduce volatility in difficult times and provide a countercyclical benefit to your portfolio.

The logic behind investing in gold

Since the creation of the Federal Reserve in 1913, the purchasing power of the US dollar has steadily declined.

US Dollar Purchasing Power

US Dollar Purchasing Power

Source: Meb Faber Research

Bonds were pretty much a wash until yields started falling in the 1980s, which boosted bond prices. However, if you had owned gold during this time and followed the law, you’d have been forced to exchange it for US dollars in 1933 with FDR’s infamous gold confiscation. Then, you would have had to invest the money elsewhere, which I guess was okay because stocks were at a generational low and you’d have quickly made a killing.

The government at the time then proceeded to jack up the estate tax to 70 percent and the income tax to 75 percent. It’s impossible to know if anyone actually paid the taxes as the vast majority of the income and estate tax burden can be avoided if you have enough money/knowledge. Even though the government indirectly funneled wealth into manufacturing/industry with the gold confiscation, gold quietly continued to appreciate over the ensuing decades. Since FDR took the US off the gold standard, the US dollar is down 98 percent against gold. Of course, if you’d invested in stocks, you’d have come out okay, but it would have been a bumpy ride.

Historically, owning gold is a good protection against government foolishness and redistribution of wealth. Today, the world is a gentler place than it was in the 1930s, 1940s, or 1970s, but the macro case for investing in gold remains as strong as ever. Though things are calm and likely to stay that way in the US and Western Europe, there are plenty of unstable countries in the rest of the world. This plays into the hands of the gold investor as instability in faraway countries boosts the macro demand for gold.

To this point, owning stocks and bonds exposes you to the same systemic risk, which is the devaluation of the US dollar, especially in the form of an inflationary shock. The good news is that you don’t need a lot of gold to protect your portfolio. I’m actually not terribly bearish on the dollar, otherwise, I’d be telling people to avoid Treasuries. However, the gold market is affected by global currency devaluation, not just the US.

Since 1968 (when good market data begins again for gold – the US government banned gold investing for a few decades in the middle), the metal has held its value nicely, delivering a 7.1 percent annual return.

In fact, since GLD was founded in 2004, it’s actually beaten equities on a price appreciation basis (equities edged out gold when you include dividends).

SPDR Gold Shares

SPDR Gold Shares

GLD data by YCharts

What efficient frontier models say about gold?

Over the last 20 years, gold has won an allocation of as high as 35 percent in the historically optimal portfolio across asset classes. In hindsight, very few people did this.

Portfolio Visualizer

Portfolio Visualizer

Source: Portfolio Visualizer

Over the last 10 years, which excludes the bull market in the 2000s, gold still wins nice allocations across the board, with up to a 14 percent allocation in the model. Gold’s correlation with equities hovers around zero, and its correlation with bonds is around 0.3. This is likely due to the fact that both bonds and gold do well in times of economic stress.

Source: Portfolio Visualizer

I’m an optimistic person, but I feel that there is a strong historical and data-driven case for investors to put a little money in gold. How much you should invest in gold depends on how much wealth you have to protect. If you have a good job but little assets, I wouldn’t worry too much about it. However, if you have some serious wealth to protect, gold helps keep you safe from inflationary pressures.

I find the figures that the model gives to be rather high. Once you include factor driven equities and bonds, the ideal gold allocation drops to my recommended range of roughly 5-7 percent. This is notably higher than the zero percent figure advocated by many personal finance gurus.

Advantages of gold over other commodities

Investing in commodities was the biggest market fad of the 21st century.

Historically, commodities have done well because they keep pace with inflation and you could play them by buying futures contracts which only required a small deposit and then investing the remaining cash in Treasury bills. During periods of higher interest rates, it’s a brilliant way to earn an inflation-protected return on your cash with moderate risk. Investors like young Ray Dalio (another believer in gold) made fortunes from doing exactly this.

During periods of lower interest rates, this is a terrible way to make money.

Another advantage of gold is the fact that the supply is limited and it has a strong demand from investors and central banks. Even if the price of gold soars, the market isn’t able to go out and mine gold the way it can produce oil, for example. When the price of oil rises, owners of oil interests all over the world clamor to pump as fast as possible. The producers inevitably overdo it at some point, giving crude oil its famous tendency to crash. You see this historically with other commodified industries too, like semiconductors. Of course, gold also benefits from having demand from industry and jewelry, which offsets the impact of new supply over time.

Gold supply, on the other hand, is slower to react to demand. Most of the easily accessible gold in the world has already been mined. Additionally, central banks have continually exhibited strong demand for gold due to its unique status as a store of value. Uncle Sam indeed continues to hold hundreds of billions of dollars in gold.

World Gold Council

World Gold Council

Source: World Gold Council

Gold bugs love to commiserate about the US government and how the feds are going to devalue the currency and create inflation, but in this case, I don’t think global central banks are buying gold mostly to protect against the dollar. The euro and yen are far more likely to see monetary chaos than the dollar is, as are a whole host of emerging market currencies.

Plus, there’s always a crisis somewhere, and when money flees dangerous countries, it tends to find its way into US dollars and gold.

Expected Return of Gold

In the long run, gold should appreciate by roughly the weighted average world inflation rate (currently a little shy of 5 percent).

This gives gold an expected return going forward of a little less than 5 percent per year with the potential for big upside if the currency of a major economy sees strong inflation like the US did in the 1970s.

Another interesting tidbit about gold is its positive skew in returns (as covered by SA contributor Daniel Goldman).

S&P vs Gold

S&P vs Gold

Source: A 47-Year Comparison Between The S&P 500 And Gold

In plain English, the skewness numbers here mean that equities tend to crash downward via their negative skew, and gold bullion returns tend to “crash upward” due to their positive skew. It’s hard to know whether this is from fiat currency or from gold, however. If you turned the graph of the dollar’s purchasing power over time upside down, you’d get a graph that looks similar to the price of gold over time.

Conclusion

Far from being a niche investment, gold is surprisingly popular as a hedge with ultra-high net worth investors and central banks. My model shows a 5-7 percent allocation through the slightly cheaper iShares gold ETF (IAU) works great for protecting your principal against equity bear markets and inflation. If you live off of your investments, periods of high inflation will hurt both stocks and bonds, potentially putting you in a tight spot. Gold gives you something that you can cash in if equities and bonds go down at the same time to sustain your lifestyle without having to sell equities or bonds at unfavorable prices.

60 percent in factor-driven equities (designed to passively exploit inefficiencies in the stock market as covered in part one and two of my data-driven ETF series), 5-7 percent gold (IAU), and 33-35 percent risk-parity bonds (5- and 10-year Treasuries + municipal bonds as covered in my Treasury futures series) soundly outperform conventional 60/40 portfolios with less risk. Understand how to trade around the market microstructure and rebalance quarterly, and you’re in great shape.

Gold can be overhyped by its most die-hard proponents, but the case for owning a little in a diversified portfolio is hard to ignore.