Protect Your Portfolio By Including 15% Gold Bullion – Here’s Why (+5K Views)

Automatically receive the internet’s most informative articles bi-weekly via our free bi-weekly Market Intelligence Report newsletter (sample here). Register in the top right hand corner of this page.

Only about 2% of ‘investors’ actually have gold in their portfolios and those that have done so have insufficient quantities to offset the future impact of inflation and to maximize their portfolio returns. New research, however, has determined a specific percentage to accomplish such objectives. Words: 1063

So says R. David Ranson in his original article*  which has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read.

Asset markets reflect inflation long before economic statistics reveal it
Over long periods of time [i.e. 50 years] the relationship of the price of gold with the cost of living is almost exactly one for one [but] the average time lag between price movements in gold and U.S. consumer-price changes is five or six years long. [As such, the] current practice that defines inflation de facto as the change in the official cost of living index can be highly misleading… For investors, inflation is ultimately nothing more or less than the depreciation of their currency and it is vital to recognize it as soon as it is reflected in asset market prices [and] for that purpose, the consumer price index is [of] no use at all.

U.S. equities underperform when the dollar depreciates relative to gold
Returns from investments such as commodities and real estate are positively correlated with gold-price movements most of the time, and so these are inflation hedges. Bonds and most stocks, however, are vulnerable to inflation because their returns tend to be negatively correlated with gold…To protect against inflation, therefore, a U.S. fixed-income or equity investor must hold inflation-hedge assets whose price movements anticipate changes in conventional measures of inflation many years before they become visible. Gold is such an asset. TIPS [Treasury Inflation Protected Securities in the U.S. and Real Return Bonds in Canada] are not.

For purposes of designing portfolios that are insured against inflation, gold again plays a double role.
1. The correlation of its price movements with those of any investment portfolio serves as an objective measure of the vulnerability of the portfolio to the dollar’s depreciation.
2. Gold is also an asset that can be included in a portfolio of stocks or bonds to reduce its vulnerability.

Sensitivity of an equity portfolio to the gold price
[First, let’s look at the correlation factor.] The correlation between the total return from an equity portfolio and changes in the price of gold is not simultaneous [i.e. approx. 5-6 years says Wainwright].

[Now, let’s review the vulnerability factor.] The average cumulative return from an investment in the S&P 500 index following a major rise in the price of gold as compared with that following a major decline [has] a time lag stretching out for three to five years [and, as such,]…the admixture of gold in an equities portfolio will reduce its volatility and protect it from inflation. The first and obvious channel is the contemporaneous inverse correlation between equity returns and the gold price change. As a result of this correlation, annual returns from the mix have a lower standard deviation than those of annual returns from either asset alone. The delayed inverse correlation is even stronger. The presence of gold protects the portfolio against damage to the portfolio that will not be felt in the form of stock market responses for several years into the future. This correlation, which is also inverse, reduces even further the volatility of the mix if we measure returns over multi-year time frames.

[To put the above in other words, gold] tends to produce particularly high returns following years in which its own price has already risen and credit spreads in the corporate bond market have widened [and] under symmetrically opposite conditions it produces very low returns. [Source: See ‘Research Summary: Systemic asset allocation strategies from market signals of growth and inflation,’ Tactical Aset Selector, Wainwright Economics, especially Figure Three.]

Measuring the riskiness of a mix of equities and gold
Naturally, the inclusion of gold in any portfolio tends to reduce the standard deviation of returns from the portfolio…the annual return from gold has a substantially higher volatility than the annual return from stocks. [As their analyses revealed:] 1. The point of minimum volatility in a mix of the two is reached in a portfolio containing 31% gold and 69% S&P 500…[while] 2. the mix that maximizes the ratio of return to risk is slightly different: 32% gold, 68% stocks…

[It must be emphasized, however, that] we are chiefly concerned here with still another distinct definition of risk: the sensitivity of the portfolio to inflation [and such an analysis suggests a different gold-to-stock split on that basis]…We know [as mentioned previously,] that the damage to a stocks portfolio from a rise in the price of gold lasts about five years… [and have determined that:]

1. the sensitivity of portfolio returns to the cumulative change in the price of gold is almost exactly zero at a mix of 15% gold and 85% stocks [and that,] according to our calculations, such a portfolio is almost exactly immune to the damage that inflation (as expressed by the gold price) does to stocks.

Investment conclusion
Including gold bullion in an equities portfolio has the effect of lowering the volatility of portfolio return and raising the return-risk ratio, just as the inclusion of any other asset would. Gold, however, has a special risk-reducing property that other assets lack. It is not only a hedge against inflation, but a market leading indicator of inflation and, better still, a direct measure of the damage done by inflation to an equities portfolio. The negative impact on stock returns from a rise in the price of gold lasts for at least five years.

We calculate that a US equities portfolio in which 15% of the assets are diverted to gold bullion would be effectively immune from damage due to a rising gold price. That is equivalent, we believe, to immunity from inflation.