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

Part II provides an examination of the role of gold in modern portfolios with a look at gold’s performance under several different types of economic regimes. The analysis then quantitatively assesses what the optimal allocation to gold in a risk-managed portfolio has been over the 40-year period studied.

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/or rising or falling economic growth. Bridgewater Associates, a large successful investment fund manager, has developed a simple conceptual graph to capture this idea:

• “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.

Chart A shows the relative frequency of these different economic regimes over the 40-year time period that was studied.

Gold has provided low correlation to both stocks (0.20) and long U.S.Treasury bonds (0.00) over the period studied and does not move in tandem with traditional asset classes. Gold had an average correlation of 0.12 to all assets studied, indicating a relatively low relationship/dependency. Clearly gold has been an excellent diversifier for a basket of basic institutional asset classes.

First, the most common portfolio definition 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, Chart C uses this typical portfolio and adds an allocation to gold to determine whether risk-adjusted returns can be increased.

To further examine the argument, Chart D compares return, risk (standard deviation), and the risk/reward ratio (Sharpe) of three different portfolio examples. The first represents an allocation of 100% gold; the second a “traditional” blend of 60% equities and 40% bonds; and an “optimal” portfolio allocating 20% gold, 48% equities, and 32% bonds.

Looking at the table, it is evident that this optimal portfolio allocating 20% to gold has had a higher return, lower risk, and higher risk-adjusted return than either a “gold-only” or a traditional “balanced portfolio.”

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.

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 has offered the following broad benefits:

• Ongoing marketplace demand in the face of limited supply.
• Historic protection from extreme market events, high periods of inflation, and devalued currencies.
• Liquidity and versatility in terms of the many forms of ownership possible for an investor.
• A time-tested, true diversifier for portfolio construction.

This article presents an excerpt from a Flexible Plan Investments, Ltd., white paper titled “The Role of Gold in Investment Portfolios” by authors David Varadi, Jerry Wagner, and David Wismer. 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 http://www.goldbullionstrategyfund.com.

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.