This article presents a number of compelling arguments for investing in gold. It explores gold’s role as a risk management vehicle that offers excellent portfolio diversification benefits and provides tail-risk protection, as well as gold’s use as a source of capital preservation that hedges against inflation and currency devaluation. Finally, this report provides some examples of academic research into the role and weighting that gold may have in an investment portfolio.
Gold has two primary functions in investors’ portfolios: as a risk management vehicle and as a source of capital preservation.
Gold As a Risk-Management Vehicle:
1. Gold provides excellent portfolio diversification due to its lack of correlation with traditional asset classes. As changes in the gold price are not significantly correlated with changes in the price of other mainstream asset classes, gold brings considerable diversification benefits to an investor’s portfolio. Importantly, this is a relationship that has been shown to hold across markets and over time.
Modern Portfolio Theory suggests that investors should hold a combination of assets in their portfolio that achieves the least volatility for a given return, or achieves the maximum return for a given exposure to volatility. Portfolio diversification allows investors to reduce the likelihood of substantial losses that may be caused by a change in economic conditions that negatively affects one or more asset classes.
The following graph shows the correlation of the monthly performance of gold to a variety of traditional and alternative asset classes and illustrates the diversification benefits of gold.
Make or Break Decision: Finding the Liquidity Provider Thats Best for YouGo to article >>
Chart 1: Correlation of gold vs. other asset classes in US dollar terms
The table below shows the year-on-year performance of five individual asset classes, which are widely considered to be relevant to Australian investors, compared with a diversified portfolio containing gold priced in Australian dollars. The red dashed line passes through the returns of a portfolio that consists of 100% Australian equities. The white dashed line passes through the returns of a portfolio that is arbitrarily diversified among property (22.5%), cash (22.5%), fixed interest (22.5%), equities (22.5%), and an allocation of 10% in Australian dollar-denominated gold, illustrating the decreased volatility achieved through diversification.
Chart 2: Improved long term average return and lower volatility through diversification
Data source: Thomson Reuters, UBS AG, Investment Solutions
The table below shows the returns and volatility of the example portfolio as discussed above. The diversified portfolio with a ten percent gold allocation has an equal return and less volatility than the diversified portfolio with no gold allocation.