Below is a chart of the progress of an investment portfolio starting in 1975 with $1 optimally allocated among ten asset classes including Gold. The magenta line reflects a portfolio always invested in each asset class according to the percentage allocations recommended by Modern Portfolio Theory and readjusted each month. The green line is a better result using a conservative combined market timing strategy that places the investor in the safety of T-Bills for the particular allocation amount that would normally be invested in that asset class when the current performance trend in that asset class is identified as significantly negative.
The results of the above chart holding a Gold component in a portfolio should be compared with the results in the next chart that repeats the same analysis but instead leaves Gold out entirely from potential consideration as a component in the portfolio.
As can be seen, the inclusion of Gold in a portfolio during this period was significantly detrimental to overall portfolio performance. Early 1970’s gains in the Gold asset class were not sustained and the effect of expecting a continuation of this performance was to hold down portfolio value. With Gold included, portfolio value is today worth about 12 to 15 times the initial investment depending on the strategy employed. But without Gold the result is higher at about 18 to 25 times the initial investment. It took until 2000 for those early Gold asset class gains to dilute sufficiently with time to the point where the recommended percentage allocations dropped to zero as seen in the allocation chart in Part 1 of this article.
Some observations:
It should be apparent that the 10% compounded average target return was not achievable over the entirety of this analysis period due greatly, but not entirely, to the recent financial meltdown. The best was a close 9.8% reached by excluding Gold as a component and using the SMC Analyzer’s conservative “Long or in T-Bills” market timing strategy enhancement. Analyses were conducted at target return percentages other than 10% but the results were similar. In fact, the more that the allure of Gold would lead the investor to invest a greater percentage of their portfolio in the metal the better off they would have been to leave it out completely. The failure of Gold to maintain the performance achieved during its first decade of public availability produced actual portfolio returns lower than predicted over the nearly 35 years of the analysis period. Other asset classes have also failed recently compared to their historical performance levels and this contributed to the inability of the recommended allocations to meet the 10% target.
Portfolio risk as measured by the standard deviation of returns was much lower with the inclusion of a Gold component but this is to be expected with the addition of a nearly completely uncorrelated asset class and with the failure of the various asset classes to produce the desired target return. The relationship between risk and reward nearly always holds true. The greater the returns the greater the risk or variation in those returns. The lower the returns the lower the variations.
The relative preservation of portfolio value during the stock market decline of 2000 to 2003 is due to an interesting result of using an asset allocation tool like the SMC Analyzer. When the history of asset class performance is limited to starting in 1970, as we did to be compatible with the start of legal Gold ownership, large stocks as an asset class are deemphasized as an advantageous portfolio component due to their poor returns in the 1970’s. Hence the investor was automatically saved from the decline at the start of this century when the market in stocks tanked. That same principle unfortunately applied in reverse for investment in Gold. It continued to be recommended based upon good 1970’s decade returns even though the overall return for the subsequent 20 years was negative.
Based on this history then it is argued that Gold has not been the sparkling portfolio component that it is frequently touted as being. Gold is sometimes utilized as a form of portfolio insurance. If all else falls then Gold is sure to go up. That is hard to dispute but the cost of that form of insurance has been very expensive.
The future:
So, given that Gold has not worked out for much of the past 30 years what does this mean for the future? Well, with the excellent recent performance of Gold during the financial crisis and the anticipation of high future inflation from all the government money being pumped today into the economy (assuming it actually gets spent) there is once again good reason to take a serious look at Gold. The SMC Analyzer’s recommended percentages for the Gold component have risen like Lazarus starting in 2006. Had you bought a small portfolio component at the $600 price level back then you would be very happy today with the price soaring to over $900 per ounce and this would have mitigated declines in some other asset classes. The current recommendation for the percent of a diversified portfolio that should be allocated to Gold (assuming a 10% overall portfolio target annual return) sits at about 12% today. If inflation once again spikes up, as it is very likely to do sometime within the foreseeable future, that allocation could come in handy as Gold prices soar far above today’s levels.