When thinking about portfolio diversification, investor minds often focus on how much in bonds to own against their stock allocations. But as we saw most recently in 2022, limiting our diversification thinking exclusively to these two asset classes can have its limits. The good news is that capital markets offer a variety of highly liquid asset classes that are widely differentiated from both stocks and bonds. And considering incorporating these allocations into a broader asset allocation strategy at an appropriate weight can provide meaningful diversification and downside risk benefits to an overall portfolio. One such category is gold.
Quarter century winner. Suppose you were presented with the following question: “what between U.S. stocks and gold has been the best performing investment category over the past 25 years?” Understandably, the answer from most investors would be U.S. stocks. After all, those of us that have been in the investing game long enough can remember like yesterday at the turn of the millennium the dubious “Dow 10000” hats on the New York Stock Exchange trading floor along with the even more notorious Dow 36000 book release (the Dow is on the brink of eclipsing 40000 today) along with the NASDAQ bubble peaking at just above 5000 (its over 16400 today) and the S&P 500 hitting all-time highs of 1553 (it is surging above 5000 today). U.S. stock performance over the last quarter century has been phenomenal.
Nonetheless, the answer to the above question is not U.S. stocks. Instead, it is gold. Since January 1999, gold has generated a cumulative return of +700% through today versus the +583% total return for U.S. stocks as measured by the S&P 500 over this same time period. Not only is gold the winner, the margin of victory is not even close at triple-digits.
About diversification. But the key from the chart above is not about the cumulative return experienced by either category over the past 25 years. Regardless of your choice, both categories performed well over this long-term time period. Instead, the far more important point is the vastly differentiated path that these two asset classes traveled along the way to arrive at their respective end points. This is where true portfolio diversification can be made.
Consider the period from 2002 to 2012. While stocks were largely dead money during this time period in the wake of the double bubbles of 2000-02 and 2007-09 along the way, gold surged relentlessly to the upside.
Consider the period from 2013 to 2018. While gold was getting routed, stocks were exploding to the upside on a wave of sufficiently sluggish economic growth and consistently easy monetary policy flowing from the U.S. Federal Reserve.
And consider the period from 2019 to the present, where both stocks and gold have been advancing strongly to the upside with their own respective fits and starts along the way.
This is what is known as being uncorrelated, and is a key principle to achieving portfolio diversification over the long-term. Regardless of whether stocks are zigging or zagging at any given point in time, gold is following its own largely independent path. And this is a good thing from a portfolio diversification perspective, for if either category heads sharply south at any given point in time, the other category has the independent ability to potentially pick up the slack. Such blending of uncorrelated assets helps smooth (read: reduce portfolio volatility) the total return experience of investors over time. One has to do nothing more than take their mouse and trace a line between the two lines in the U.S. stocks versus gold chart above to see how it works.
Uncorrelated. Let’s take a brief dip into the statistics. The correlation of two assets is measured on a scale between -1.00 to 0.00 to +1.00.
If the correlation reading is positive, it means two assets are likely to move in the same direction over time. The higher the positive reading toward +1.00, the more positively correlated two assets are. For example, while a core U.S. bond strategy has a low positive correlation at +0.21 with U.S. stocks (this is a fairly good diversification reading), the reason that many say high yield bonds trade more like stocks is because they have a relatively correlation to the S&P 500 of +0.74.
Conversely, if the correlation reading is negative, it means two assets are likely to move in the opposite direction over time, with the higher the negative reading toward -1.00, the more negatively correlated the two assets are. Thinking about the stock/bond relationship, its worth noting that long-term U.S. Treasuries have a low negative correlation at -0.13 with U.S. stocks, thus packing an added portfolio diversification punch relative to a broader core bond strategy for an investment portfolio when stocks are falling (the fact that long-term U.S. Treasuries also have a meaningfully higher standard deviation of total returns than a broader core bond strategy is also an important key from a diversified portfolio construction standpoint, but this is a more in depth discussion for another day).
So what about gold? The yellow metal has a +0.09 correlation to U.S. stocks. The closer the reading to 0.00 between two assets, the more uncorrelated (and independently moving) these two assets are. In short, gold is virtually uncorrelated with U.S. stocks. (Bonus note: gold also has a low positive correlation at +0.22 to both a broader core fixed income strategy as well as long-term U.S. Treasuries – not only is gold essentially uncorrelated with stocks, they are also largely uncorrelated with bonds – good stuff from a portfolio diversification standpoint).
Worth its weight. OK, so gold can provide a diversification benefit in the broader portfolio construction process, but what kind of weighting in the portfolio makes reasonable sense? The answer of this question can vary widely and is dependent on the return expectations, risk tolerance, income needs, and time horizon of each individual investor. But it is worthwhile to share some key guiding principles that may be worth consideration.
First, owning gold in isolation is not for the faint of heart. It has a price volatility that is more than 10% higher than that of U.S. stocks as measured by the S&P 500, which is a more volatile category in its own right. This higher volatility is useful in the broader portfolio construction context, because it means that a relatively smaller weight to the category can still pack a meaningful total return punch to provide the diversification benefit. But viewed in isolation, this volatility can be disquieting, particularly when gold enters into a more price swinging stretch as it has on a number of occasions during its history.
Next, gold is a real asset. It hurts when you drop it on your foot. But it does not generate cash flows and it does not kick off income. As a result, for investors prioritizing income generation from their portfolio, it is a less than ideal component.
As a result and more often than not, it is worthwhile to view gold in an “insurance policy” context from a portfolio construction perspective for those that may be interested in considering the possibility. Not a huge weighting, but just enough to provide the portfolio diversification benefit when needed. This often lands the weighting to gold in the low to mid-single digit percentage range of an overall portfolio at most for those investors that have the appropriate risk tolerance and time horizon.
Bottom line. When thinking about broad portfolio diversification, investors may be well served to expand their thinking beyond the traditional asset classes of stocks and bonds. For even a small weighting to an asset class like gold for investors where such an allocation is appropriate can make a meaningful difference in lowering portfolio risk and improving risk-adjusted returns.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice.
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