10.15.2011

Gold and Asset Allocation: Less Risk, More Return

One of the basic principles of investing is that expected return increases with risk. The "safest" investments like FDIC-insured CDs and short-term Treasuries have essentially zero risk of loss of principal, but you will earn close to zero on them. Corporate bonds are riskier but will return more on average. Stocks are still riskier but can be expected to earn even more, perhaps several percentage points above inflation over the long run.

The range of possible optimal portfolios then looks something like this, with cash and conservative bond-heavy portfolios in the lower left corner and aggressive stock-heavy portfolios in the upper right. The below, from Charles Schwab, is based on actual returns since 1/1/2009 for various mixes of cash, bonds, large cap, small cap, and international equity. This was a period of strong market returns, so the numbers are higher than long-run expected returns, but the shape of the curve is the same.

On the vertical axis is annualized return, and on the horizontal axis is the volatility (standard deviation of returns) of the portfolio, which is "risk" as defined by academics and investment practitioners (which is a silly way to define risk, but that's a discussion for another day).


Portfolios that lie below the curve are by definition bad portfolios -- taking on too much risk for the amount of return they earn. The Holy Grail would be to be able to build a portfolio that lies above this curve. Which, incidentally, is what you've done if you added gold to your portfolio.

The below portfolio returns are the actual results of an actual investor following the Varones investment strategy of mostly stocks with some cash and gold thrown in.




Given what gold has done has done the past few years, it's not surprising that adding a little gold increased portfolio returns. But what's really beautiful is how gold also reduces portfolio risk. The portfolio returned more than Schwab's "Aggressive" model, but had volatility in line with the "Moderate" model. This has been true long before gold's recent surge. It's because the correlation of gold with other asset classes like stocks, bonds, and real estate is low and even sometimes negative. All this information was available to anyone five years ago, and if gold returns were plugged into any asset allocation model, it would have recommended at least a few percent in gold. And all this is completely apart from, and in addition to, the fundamental reasons this blog has been pounding the table on gold the last few years. So if your financial advisor left you with a zero weight in gold, she's got some 'splaining to do.

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