Why an Asset Allocation of 5 Percent for Gold is Too Low

It’s not been a good month for gold as the price has dipped from about $1,750 an ounce to under $1,670, two large sell-offs in recent weeks accounting for the bulk of that $80 decline and once again spurring talk of manipulation in the gold market.

Who is responsible for these market-moving sell orders and why they’re doing it remains a mystery, however, since the long-term fundamentals for the yellow metal remain quite good - fading confidence in paper money, low real interest rates, and strong demand from emerging market central banks and global investors to name just a few - investors with little or no gold exposure might want to consider taking advantage of the lower prices now being offered for gold and silver.

But what asset allocation is appropriate?

Now that the precious metals bull market has gone on for more than a decade, it’s become conventional wisdom that investors should allocate a small portion of their assets to gold, silver, or mining stocks and the figure I hear most frequently is five percent.

A good example of this thinking comes via the concluding paragraph of this Marketwatch story from earlier in the month:

So I’m holding on to a small gold position (5% of my investable assets) and waiting to see how far the sell-off goes. If gold stabilizes in the low to mid-$1,600s I might buy a little more, but not much. The big decade-long bull market in gold may be in its last innings, but I wouldn’t mind a little more cheap insurance in case the game goes on a little longer.

Now, one look around the financial world today should avail anyone of the notion that the gold bull market is “in its last innings” - not much has really changed since the 2008 financial crisis, that is, aside from the size of central bank balance sheets and government budget deficits - but this does serve as a good example of this thinking about a five percent asset allocation to precious metals.

On a recent trip back East to visit relatives, my aunt proudly told me she had some money invested in gold (apparently she’s heard a lot about how my wife and I sold our California house almost a decade ago, directing a good portion of those proceeds to the barbarous relic) and she decided to take the plunge as well.

She said she had about a five percent allocation - that’s all her investment adviser would conscience.

I remember saying something like, “Well, five percent really won’t do you much good”, and that has led to today’s exercise showing how various asset allocations to the yellow metal would have affected a theoretical 60% stocks/40% bonds investment portfolio over the last decade as shown below.

The chart includes data through yesterday, December 18th, 2012, and uses two of the biggest funds in the world for stocks and bonds - the SPDR S&P500 ETF (SPY) and the Pimco Total Return Fund (PTTRX) - in a 60%/40% mix that is reduced as gold is added. For example, for a 50 percent allocation to gold, the stock holdings start out at 30 percent and the bond holdings start out at 20 percent, then the portfolio is rebalanced at the end of every year.

As shown in only the slight difference between the red and blue curves above, there isn’t much difference between a 5 percent asset allocation to gold and having no gold at all. That situation changes rather dramatically, however, as gold holdings are increased.

Note that you can start out in any year except for 2012 and still come out better off the more gold you hold. Picking the end of 2005 as a start date so as to begin with the nearly 16 percent gain for stocks in 2006 puts the zero gold portfolio up 50 percent while a 25 percent gold weighting produces a gain of 84 percent and a 50 percent gold weighting results in a gain of 124 percent.

Also, changing the stock/bond mix has little effect on the improvement that is seen when more gold is added, however, for obvious reasons, the results you get are highly dependent on the start date since stocks and bonds often move in different directions.

Of course, putting a 100 percent gold portfolio on the chart would have messed up the right-hand scale quite a bit, but, for anyone who’s interested, it would have produced a result of 598, or almost a 500 percent return as compared to a return of just 36 percent for stocks and 127 percent for bonds since 2000.

While it would be presumptuous to think that the next decade will see another 500 percent rise for gold - that would put the gold price at about $10,000 an ounce - given the precarious state of the global financial system and the inclination for central banks to print money first and ask questions later, anything is possible.

Those thinking that their current five percent asset allocation to gold might actually be helping them if the next ten years look anything like the last ten years might want to study the chart above.