Is it crazy to own gold?

I hope you had a great July 4th!

Gold is a controversial asset.

Feelings about gold tend to be separated into two camps:

  1. Stock people who hate the asset. They don’t understand why anyone would invest in an asset that generates no income with no future prospects for growth. Stocks pay dividends and generate earnings. Bonds at least pay interest. For gold, there is no intrinsic value other than what other people are willing to pay for it. I was in this camp for a long time.
  2. Perma-bears who love the asset. The Fed is destroying the monetary system and blowing up bubbles. So, the only safe haven from a dollar that is being slowly decimated by the Fed is a hard asset, like gold.

My asset allocation has a 20% allocation to gold. I don’t go all-in the asset, but I think it serves an effective role in a portfolio. It tends to cushion drawdowns, although not as well as treasuries.

Long term treasuries remain the champion of performance during massive stock drawdowns:

With that said, I’m not comfortable putting 40% of my portfolio in treasuries. I don’t believe treasuries are truly “risk free.”

The greatest risk to treasuries is inflation. Inflation would prompt the Fed to increase interest rates, which would crush treasury prices. Inflation would also make the interest and principal payments more and more worthless.

I previously had TIPS in my asset allocation as my inflation protection, but this is flawed because TIPS rely on official government statistics on inflation.

If the US government wanted to hurt TIPS investors, it could simply manipulate the inflation statistics and change the inflation yardstick. I’m not going full “shadow stats” and don’t think the government is currently doing this, but I don’t think it it outside of the realm of possibility in the future.

Meanwhile, gold is a defensive asset. Like treasuries, gold can cushion drawdowns. Unlike treasuries, it has a track record of performing well during periods of dollar weakness and high inflation.

I don’t advocate a massive allocation to gold and I don’t think that the global economic system is about to unravel because of the Fed’s insanity, but I have 20% of my portfolio in gold because inflation (and a weaker dollar) is a real danger and gold is also an effective way to contain this risk.

I think a good way to demonstrate the usefulness of gold in a portfolio is to look at it through the perspective of a truly crazy portfolio: 50% US market cap weighted US stocks, 50% gold.

This portfolio is indeed crazy. I don’t actually advocate putting 50% of a portfolio in gold, but I think that this crazy portfolio helps demonstrate why gold is a useful asset in a portfolio.

Before I looked at the data, I assumed that a massive allocation to gold would weigh down on returns. Shockingly, it does not. In fact, the 50/50 portfolio slightly outperforms the returns of 100% stocks with less severe draw-downs and less volatility.

On its own, gold is an absolutely terrible investment. Massive volatility, an extremely long drawdown & recovery (gold entered a drawdown in 1980 and didn’t fully recover until 2007), and it has little promise to ever outperform US stocks.

But – in a portfolio – gold can do extraordinary things. It helps reduce drawdowns and it tends to do well in decades when stocks are not doing well.

Gold demonstrated extraordinary performance during the 1970’s, but it also did well during times like the early 1930’s. Gold prices tend to rise during periods of growing fear, as investors flock to “hard assets.” The flock to hard assets is what occurred during the Great Depression. As people gathered gold, the price rose, rising from $20.63 in 1929 to $26.33 in 1933, a 27% increase during a period when stocks were down nearly 80%.

When rebalanced with stocks, it helps deliver a great result: less volatility and cushioned drawdowns.

The interaction between stocks and gold in the 50/50 portfolio is something I’ve noticed with a lot of asset allocations: an investor gets a result that is greater than the sum of the parts.

One would assume – for instance – that the return would simply be an average of the return for the two asset classes. Gold has a CAGR of 7.8% since 1972. Stocks have a CAGR of 10.25%. Averaged together – it is 9.025%.

However, in a portfolio, the actual result is 10.29%. It’s greater than the expected average of 9.025%. It’s greater than the return of either asset. The result is greater than the sum of the parts.

As David Swensen points out, asset allocation is the only free lunch in investing.

This is because gold and stocks are truly uncorrelated. They are almost inversely correlated.

By regularly rebalancing, an investor is able to sell gold when it is up and then buy stocks when they are down. This regular process of rebalancing enhances returns by buying each asset class after poor performance and selling each asset class after strong performance. Meanwhile, thanks to the interaction of the asset classes with each other, drawdowns and volatility are reduced.

Just to reiterate: a 50% allocation is too much for my tastes, but I think this is a useful experiment to show how an allocation to gold isn’t completely crazy and it can serve as an effective defensive asset in a larger portfolio.

For my portfolio, my defensive allocation is split between long term treasuries and gold. Long term treasuries perform better during large drawdowns. However, long term treasuries will be decimated in a period of rising inflation and interest rates. For that reason, I split the “defensive” slice of my portfolio between both gold and long-term treasuries. You can read about my passive allocation here.

Random

U2 at Live Aid in 1985.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.