Monday, May 16, 2011

What Role Should Gold Play in A Diversified Portfolio?

There was a good article in yesterday's New York Times titled "For Gold Investors, a Sudden Reminder of Its Volatility" which I thought was pretty interesting.

Written by Jeff Sommer, the column questioned the use of gold, or any other commodity, as an effective tool to reduce risk in a diversified portfolio.

Most presentations discussing the positive aspects of investing in gold use the early 1970's as a starting point. Gold in 1971 was trading at $35 an ounce before President Nixon took the United States off the gold standard. Gold then proceeded to soar in value, helped by the high inflation rates experienced in this country during the late 1970's. By 1980, gold was trading at $850 an ounce.

Today gold is trading around $1,500 an ounce, which of course is considerably higher than a year ago but represents a meager 0.8% compound return over the last 31 years. Moreover, if gold had simply kept pace with inflation, gold would be trading a $2,400. Viewed from this perspective, then, the case for holding gold in a diversified portfolio becomes much less compelling.

So how should an investor properly structure a diversified portfolio?

Mr. Sommer cites some pioneering research work done by Gary Brinson in the 1980's and early 1990's. Brinson's papers from the Financial Analysts Journal are required reading for CFA candidates, since they represent some of the basic foundations on which many portfolios are constructed today.

As Mr. Sommer discusses:

In two papers in the Financial Analysts Journal, {Gary Brinson} and several colleagues found that broad decisions about asset classes... accounted for more than 90 percent of a portfolio’s performance.

He concluded that eight asset classes — none of them gold or any other commodity — were all that an investor needed. For a model “moderate risk” portfolio under normal market conditions, he said in the interview, those eight and their allocations are: stocks from developed markets, 49 percent; emerging-market stocks, 6 percent; investment-grade bonds from developed markets, 25 percent; emerging-market bonds, 2 percent; high-yield bonds, 3 percent; commercial real estate, 10 percent; and private equity and venture capital combined, 5 percent.

Interesting stuff.

For Gold Investors, a Sudden Reminder of Its Volatility -