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Can investing in gold create a more optimal portfolio allocation?

by Aug 10, 2016UpClose

The role of gold in investment portfolios: Part II
Updated analysis supports an optimal portfolio allocation to gold of 25%.

Editor’s note: A revised and updated version of this article can be found here.

Flexible Plan Investments, an active money manager and provider of risk-managed investment services, first authored an extensive analysis of the role of gold in investment portfolios in 2013. This white paper has been recently updated and is being presented as a guest commentary in two parts in Proactive Advisor Magazine. Last week’s Part I examined broad issues related to how investing in gold performed in specific market environments.

We are pleased to present Part II here, which looks more closely at gold’s performance in classic market regimes and offers broad conclusions on optimal gold allocations for investment portfolios. This analysis suggests an optimal gold allocation of 25%, which produced higher risk-adjusted returns than any other portfolio alternative.

Performance of gold in different economic regimes
It is clear from the examples and analysis presented in Part I that gold can provide favorable returns and act as an important counterbalancing portfolio component under a variety of very specific market and economic conditions.

But, how does gold perform under different classic economic regimes?

A popular concept in modern portfolio theory is the “All Weather” definition of economic regimes, with four different “states of the world” characterized by either rising or falling inflation and rising or falling economic growth. Bridgewater Associates, the large and very successful hedge fund mentioned earlier, has developed a simple conceptual graph to capture this idea (Figure 9).

In our analysis, we considered the different environments that could be characterized by the change in both inflation and economic growth, and then created our own identifying labels:

“Normal”: Real economic growth rate (GDP) is rising and inflation (CPI) is rising.

“Ideal”: Real economic growth rate (GDP) is rising and inflation (CPI) is falling.

“Stagflation”: Real economic growth rate (GDP) is falling and inflation (CPI) is rising.

“Deflation”: Real economic growth rate (GDP) is falling and inflation (CPI) is falling.

Figure 10 shows the relative frequency of these different economic regimes over the 43-year time period that was studied. As you can see, the most frequently occurring economic state (77%) was what we call “Normal,” characterized by rising economic growth and rising/moderate inflation.


Since 1981, Flexible Plan Investments (FPI) has been dedicated to preserving and growing wealth through dynamic risk management. FPI is a turnkey asset management program (TAMP), which means advisors can access and combine FPI’s many risk-managed strategies within a single account. FPI’s fee-based separately managed accounts can provide diversified portfolios of actively managed strategies within equity, debt, and alternative asset classes on an array of different platforms. FPI also offers advisors the OnTarget Investing tool to help set realistic, custom benchmarks for clients and regularly measure progress.


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About Us
The role of gold in
investment portfolios
This two-part guest commentary
by Flexible Plan Investments explores
why investors should reconsider
their portfolio’s allocation to gold.

Part I: Gold’s performance in
specific market environments

This is to be expected, as most central banks around the globe tend to target a 2%–3% annual inflation rate, and governments and private industry obviously attempt to achieve economic growth over time.
In contrast, the extreme opposite situation, “Deflation,” fortunately has occurred relatively infrequently (2%). This is the destructive situation where both economic growth and inflation are falling. Japan is a modern case study of the deleterious effects of deflation. (The longest and most notable period of deflation in the U.S. was during the Great Depression, which is outside of the time frame of our study.) Governments generally attempt to avoid this situation at all costs, even if that means printing money and creating temporary excess inflation.

“Stagflation” is a situation where inflation is rising and growth is falling. This has occurred roughly 12% of the time. The most notable example of stagflation was during the 1970s when inflation was high, partially due to the energy crisis, and the economy endured some difficult times.

Finally, “Ideal” conditions are defined as the period where inflation is falling but economic growth is robust and rising. This regime was present roughly 9% of the time. This is a great environment for business expansion and for investors in many asset classes. The 1990s is the best example in recent U.S. history of an “Ideal” period.

Figures 11 through 14 summarize the performance of the various asset classes during each of these economic regimes.

There are several takeaways from this analysis pertinent to gold:
  • In the most commonly occurring circumstance of “Normal” economic conditions, gold finished a close second to equities in terms of average annual return.
  • In “Ideal” conditions, equities provided the best performance.
  • However, in the two most negative economic regime conditions, gold far outperformed equities. In fact, in times of “Stagflation,” gold provided vastly superior returns to any other asset class.
  • “Stagflation” tends to happen slightly more frequently than “Ideal” economic conditions (12% versus 9%), creating quite an interesting “trade-off” between gold’s performance and that of equities under these two regimes. Gold provided positive returns during both periods, while equities only had positive returns in one. Still, gold underperformed equities significantly during “Ideal” conditions. Yet, during periods of “Stagflation,” gold’s 16.37% annualized gain versus equities’ 22.47% loss is certainly a compelling statistic.
This, once again, reinforces the case for gold as an important portfolio diversifier. Gold provided positive returns under most market conditions (98% of the time in the last 43 years, as shown above). Gold may not outperform equities in times of normalcy and growth, but it has greatly outperformed equities in times of market stress and less-than-ideal economic conditions. Because such times have had the greatest negative returns for traditional equity portfolios, gold can have a significant effect on long-term portfolio volatility.
Gold as a diversifier versus other asset classes
The analysis presented illustrates that gold can provide diversification in several different economic regimes, each of which lies somewhere on the future economic horizon. But how does gold move in relationship to traditional asset classes like stocks and bonds?

As Figure 15 illustrates, gold provided a low correlation to both stocks and bonds and did not move in tandem with traditional asset classes.

(Adjusted for Inflation)
One of the statistical measures used to capture this relationship is the correlation coefficient, which ranges between 1 and -1. A coefficient of 1 indicates that a pair of assets move in perfect tandem, while -1 indicates that a pair of assets moves in an opposite or alternating fashion. Table 1 shows the correlation of gold for a basic set of institutional asset classes.
(January 1974–December 2015)
Gold had an average correlation of 0.06, indicating almost no relationship/dependency with other basic asset classes. Gold had the highest correlation to the CRB Futures Index, which is to be expected because this represents exposure to the commodities sector, which includes gold. Clearly gold has been an excellent diversifier for a basket of basic institutional asset classes.
Optimal portfolio allocations to gold
The study by Oxford Economics referenced in Part I shows the optimal allocation to gold is 5%, assuming 2.2% growth and 2% inflation. Under the conditions where inflation was higher, the optimal allocation was also found to be higher than 5%, and the same was true for conservative investors in a low growth/low inflation scenario.

In a 2006 study, Richard Michaud, Robert Michaud, and Katharine Pulvermacher of New Frontier Advisors demonstrated that gold was part of the optimal portfolio for investors at all levels of risk preference tolerances—not just for a balanced investor. Adjusting for uncertainty and seeking the most robust solution, Michaud et al. found that for risk-level tolerances consistent with a balanced investor (around 10% risk), the optimal allocation to gold was found to be above 10% in the base-case scenario using multiple asset classes and historical market data.

Figure 16 is from the Michaud et al. study. It shows the optimal portfolio weight in gold and the maximum (upper) and minimum (lower) allocations at different levels of target portfolio risk.

Using a more conservative set of assumptions with estimated portfolio inputs, Michaud et al. found that the optimal allocation to gold was close to 5% at risk levels consistent with a balanced investor. Figure 17 shows the optimal portfolio weight in gold and the maximum (upper) and minimum (lower) allocations at different levels of target portfolio risk in their conservative case.

But, has gold boosted risk-adjusted returns for a more typical portfolio? What has the optimal allocation to gold been for a typical portfolio?

These are more important questions than finding the optimal allocation across a broad universe of asset classes that are more commonly held in large pension portfolios.

First, we define typical: The most common portfolio is one that contains a 60% allocation to equities and a 40% allocation to bonds, or what the literature might refer to as a traditional “balanced portfolio.”

As a test of gold’s possible diversifying power, we can use this typical portfolio and add an allocation to gold to determine whether we can increase risk-adjusted returns. We will represent stocks in the portfolio with the Vanguard Total Stock Market Index, and for bonds we will use the 10-year Treasury Total Return Index. (See Table 2.)

Figure 18 shows the risk-adjusted return ratio (Sharpe) as a function of the allocation to gold from 1973 to Dec. 31, 2015.

Note that all of the blue “dots” left of the vertical center line are portfolios that dominate a balanced portfolio in terms of risk-adjusted returns. In finance parlance, these portfolios are considered to lie on the “efficient frontier.” Table 2 shows a more complete breakdown, providing data points for various levels of allocation to gold and the resulting total portfolio risk/reward ratio. All portfolios with allocations to gold highlighted in green have been superior to a traditional balanced fund in terms of risk/reward ratio (0.74).

As Table 2 demonstrates, it has been possible to allocate as much as 45% to gold in a portfolio and still have a superior risk/reward ratio to a portfolio that only holds a balanced fund. The optimal allocation from a risk/reward standpoint has been to allocate 25% to gold and 75% to a balanced portfolio.

This is 5% higher than was optimal when we first released our analysis in 2013. In terms of returns, all three asset classes offered less to investors than they did in our last study. In such an environment, diversification becomes more important than returns in creating the best risk-adjusted portfolio. Because the correlation between the asset classes has not changed much from when the previous study was performed, the amount of gold included in a portfolio to reach Sharpe optimality is higher.

Table 3 compares this “optimal portfolio” with both gold and a balanced portfolio.

Looking at Table 3 we see that this optimal portfolio has had a higher return, lower risk, and higher risk-adjusted return than either a “gold-only” or a traditional “balanced portfolio.” The higher return for the optimal portfolio may seem counterintuitive, but the low correlation of gold to a balanced portfolio permitted a gain in returns from periodic rebalancing (monthly in this case).

Concluding thoughts on the evidence
Our study demonstrates that adding gold to a typical/balanced portfolio has been beneficial across a wide range of allocations in terms of boosting risk-adjusted returns. Unexpectedly, over the 43 years studied, the optimal allocation has actually been 25% to gold and 75% to a balanced portfolio, representing a mix of roughly 45% stocks, 30% bonds, and 25% gold. In fact, investors could have allocated as much as 45% to gold based on historical analysis and still fallen on the frontier of efficient portfolios that dominate holding a pure balanced fund.

Both the optimal (25%) and upper range of efficient portfolios (45%) may seem fairly high relative to the 5% “rule of thumb” allocation to which a large number of financial advisors seem to subscribe. But there is precedent. The “Permanent Portfolio” by Harry Browne recommends an equal weighting (25%) across stocks, bonds, cash, and gold as being optimal across different economic regimes. We believe the evidence presented here strongly suggests that the current prevailing “conventional wisdom” greatly understates the potential role of gold in portfolios for a typical investor over the long term.

Every investor should reconsider their portfolio’s current allocation to gold
Based on our 43-year study, it appears most investors are likely underinvested in a full range of investment alternatives, and specifically in gold as a long-term asset class. Research suggests that an allocation to gold over the long term can be as high as 45%, while still providing better risk-adjusted returns in various market environments as compared to the traditional “60/40 balanced” investment portfolio.

For investors, who have understandably grown more concerned about capital preservation in times of macroeconomic risk, but who are still looking for optimized returns, gold should be strongly considered as a key portfolio element. Over the long term, gold offers the broad benefits of (a) ongoing marketplace demand in the face of limited supply; (b) historic protection from extreme market events, high periods of inflation, and devalued currencies; (c) a time-tested component of portfolio diversification; and (d) liquidity and versatility in terms of the many forms of ownership possible for an investor.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

This article presents an excerpt of the white paper, “The Role of Gold in Investment Portfolios.” The complete paper—including a list of source data and an appendix on the quantified definition of bull, bear, and sideways markets—can be found at

Past performance does not guarantee future results. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding 12 months is available upon written request.

This white paper is provided for information purposes only and should not be used or construed as an indicator of future performance, an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Flexible Plan Investments, Ltd., cannot guarantee the suitability or potential value of any particular investment. Information and data set forth herein has been obtained from sources believed to be reliable, but that cannot be guaranteed. Before investing, please read and understand Flexible Plan Investments, Ltd., ADV Part 2A and Part 2A Appendix 1.

The original white paper, published by Flexible Plan Investments November 2013, was written by David Varadi, David Wismer, and Jerry C. Wagner. The updated white paper, published in April 2016, was revised by Jerry C. Wagner, Jason Teed, and Liangbo Yu.