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Many investors have been thinking about gold recently. Some have considered it because it has been a relatively strong performer with the iShares COMEX Gold Trust (NYSEARCA:IAU) closing up 5.4% in 2008. It’s up 2% year-to-date as of Wednesday’s close. The iShares S&P 500 Index ETF (NYSEARCA:IVV) was down 36.94% in 2008 and is down 6.17% year-to-date as of Wednesday’s close. Other investors or traders have bought or considered gold as a classic safe haven.

My inclination is to refute the efficacy of buying or holding gold for security either in the form of an ETF or, more so, in the case of gold bullion bars or gold coins. However, as the financial crisis became more severe last year, a couple of clients approached me about adding gold to their portfolios. Rather than diplomatically rejecting the proposal, I told them that I would investigate the historic effects of holding gold in a portfolio. Long story short, I found that adding a small, reasonable allocation to gold reduced portfolio volatility substantially and increased return slightly.

A simple diversified portfolio consisting of 1/3 S&P 500, 1/3 Real Estate Investment Trusts (REITs), and 1/3 10 year U.S. Treasuries would have produced a compound annual growth rate (CAGR) of 8.47% with 11.15% volatility (standard deviation – SD) from 1993 to 2008. For comparison, the S&P 500 produced a 6.67% CAGR with a 20.16% SD. Although few investors would implement this 1/3 – 1/3 – 1/3 allocation, diversification is proving its strengths here. All of these statistics incorporate rebalancing annually.

Let’s take the same 1/3 – 1/3 – 1/3 portfolio and alter it to include a relatively small allocation to gold. That allocation will be 30% S&P 500, 30% REITs, 30% Treasuries, and 10% gold. Over the same timeframe the portfolio with gold produced an 8.49% CAGR with a 9.86% SD. The portfolio with gold produced a slightly better CAGR with volatility that was 11.6% lower than the 1/3 – 1/3 – 1/3 portfolio. The diversified portfolio with gold produced a CAGR that was 27.3% higher than the S&P 500 and 51.1% less volatile than the S&P 500. The S&P 500 had 4 losing years with the worst being a loss of 37% last year. The 1/3 – 1/3 – 1/3 portfolio had 3 losing years with the worst being a loss of 18.15% last year. The portfolio with gold had only 2 losing years with the worst being 15.74% last year.

In constructing sound and productive portfolios we would like to include assets that have high returns, low volatility, and low correlation to the other assets in the portfolio. Looking at gold’s average annual returns, relative volatility, and relevant correlations, one should expect that gold would be a constructive addition to many portfolio allocations. In fact, gold even has a relatively low correlation with commodities in general (S&P Goldman Sachs Commodity Index). However, we should learn from the past but not expect it to repeat itself exactly. There is much to be learned from historic returns, volatilities, and correlations of asset classes. With all due respect to history and math, we must use reason when constructing portfolios. I view gold as a very narrow and idiosyncratic asset. So, I do not feel that it is wise to strategically allocate as much as 10% to the asset although the historic, mathematically optimal amount would be higher in the context of some portfolios.

What did I do? Based on my tests and observations, I bought a little gold last year for some of my clients. I have incorporated a small allocation to gold into their continuing strategic allocations.

Source: Gold as Part of a Portfolio