Gold vs. Bonds as an Asset Allocation Hedge

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Xile F Investor
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Gold vs. Bonds as an Asset Allocation Hedge

Post by Xile F Investor »

On this forum I've seen lots of posts about how Gold's long term value growth is 0%, which is valid if one looks at Gold as a stand alone investment. And I've seen alot about the cost of owning Gold over the longer as well. But what I've seen less analysis of Gold as a part of one's Asset Allocation, over the long term.

Can anybody point me to long term (20, 30, 40+ years) analysis of something like 60/40 Stocks/Gold vs. 60/40 Stocks/Bonds vs. 60/20/20 Stocks/Bonds/Gold, with annual rebalancing?

Seems as though Gold has some value in a periodically rebalanced portfolio, as its correlation to stocks and Cash is low.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by TrustNoOne »

I don't think there has been nearly as much research on gold as part of an overall portfolio as the case for stocks and bonds. I'd be intersted in seeing what it does to SWR's, for ex.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by nisiprius »

It would be meaningless because gold's behavior is so tied to individual, unique, unpredictable historical events. The results for any particular retirement year would vary utterly depending on start and end points, and it would take more data than is available to get reliable averages.

What is the average number of times per century that Nixon takes us off the gold standard? What is the average number of times per year that Roosevelt prohibits private ownership of gold? You just can't factor that stuff into statistics.

I mean, really, just think. If your investment horizon was any time in the century before 1934, your gold investments had a value of precisely $20.67 an ounce throughout your lifetime, zero nominal return, somewhat varying real return... and its effect on your SWR, etc. would have been bad. Ditto 1934 to 1971, when it was $35, except that $35 in 1971 had less buying power than $12 in 1934. Gold did not act as a "store of value" over that time period.

If 1980 occurred within your investment time frame, your results depended utterly on what assumptions you make about when and whether you sold, and what your rebalancing strategy was. And notice that on on January 22 1980 gold dropped from $850 to $737 in ONE DAY, and then to $695 in the NEXT DAY... an 18% loss in two days. So I mean it really mattered how you rebalanced. Your results for any period including the year 1980 will vary by big amounts depending on what you assume for your investing strategy.

If your investment time frame falls within 1834-1934--and if you can trust e.g. Siegel's statistics for the stock market for that time period--gold would have hurt your portfolio results quite a lot. If you invested in gold any time in the last 10-20 years and you sell right now, gold will have improved your portfolio results quite a lot.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Index Fan »

It would be meaningless because gold's behavior is so tied to individual, unique, unpredictable historical events. The results for any particular retirement year would vary utterly depending on start and end points, and it would take more data than is available to get reliable averages.
This is a fair point. However, the same reasoning could be applied to the bond market, with the last 30 years being characterized by a long-term fall in rates that could be seen as a unique historical event unlikely to be repeated anytime soon, for example.

Perhaps this is true of investment returns in general. It's something to think about, anyway.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by nisiprius »

Index Fan wrote:
It would be meaningless because gold's behavior is so tied to individual, unique, unpredictable historical events. The results for any particular retirement year would vary utterly depending on start and end points, and it would take more data than is available to get reliable averages.
This is a fair point. However, the same reasoning could be applied to the bond market, with the last 30 years being characterized by a long-term fall in rates that could be seen as a unique historical event unlikely to be repeated anytime soon, for example.

Perhaps this is true of investment returns in general. It's something to think about, anyway.
You're right, and I do wonder about it. The forty years from 1940 to 1980 in the bond market seem to be just as unique. I would make a weak case that individual point events, and decisions made by very small numbers of people in government, have had played a relatively larger role in the behavior of gold than in the behavior of bonds and stocks. Certainly point events have effects--like Federal Reserve actions on bonds, or the end of the fixed brokerage commission on stocks--but a chart of stock or bond prices doesn't have long flat lines and sharp corners on it.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by A Devout Indexer »

Index Fan wrote:
It would be meaningless because gold's behavior is so tied to individual, unique, unpredictable historical events. The results for any particular retirement year would vary utterly depending on start and end points, and it would take more data than is available to get reliable averages.
This is a fair point. However, the same reasoning could be applied to the bond market, with the last 30 years being characterized by a long-term fall in rates that could be seen as a unique historical event unlikely to be repeated anytime soon, for example.

Perhaps this is true of investment returns in general. It's something to think about, anyway.
But with bonds you can measure the return of various durations over a period with no net interest rate changes (such as '64-'05--when 1mo bills did +5.8%, 1yr notes did +6.8%, 5yr notes did 7.4%, and 20yr bonds did 7.6%), with stocks you can look at a period where net P/E or P/B ratios are unchanged (for example, the approximate P/b ratios of large/small and value/blend/value are similar today to the average for the total 73-'10 period, over which time the S&P 500 did +9.8%, large value did +12.8%, small blend did +12.2%, and small value did +16.8%).
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Xile F Investor »

So, I'm far from the sophisticated investor, as some of you seem to be, but I'm doing my best to catch up on the my reading from the book list. But, seems as though you all are saying that, since historically we can match a pattern to the behavior of gold, that it's not worth analyzing as a diversifier for AA? But isn't that exactly what we are looking for? Something with no correlation to our other assets in our portfolio?

I'm not promoting Gold, I've stopped investing in it in my portfolio. I just want to make sure I understand why I invest in one thing, and not another.

Again, for any new readers, this is not about Gold as a stand alone investment, but Gold as part of an AA.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by rmelvey »

Xile F Investor,

Many on this forum are very opinionated against gold. You will find that many investors think they cannot predict stock price, or bond prices, yet they somehow clearly know the future direction of gold prices.

My take:

Gold has been an excellent diversifier over the last 40 years, ever since its price was allowed to float. As long as the price continues to float, I think it will continue to be a strong diversifier.

Now, many people dismiss gold because it does not pay dividends or interest, or because it just sits there. Ironically, that is the very reason gold is such a good hedge. Dividends and interest payments are promises, and sometimes promises are broken. Gold just sits there, being gold.

Under healthy economic conditions, there is little to like about gold. However, when people stampede out of risk assets they look for alternatives; you can only hold so many US dollars before you start looking for something different.

Don't let anyone use gold's differences as a reason to not hold it, it's differences are what makes it so attractive in a diversified portfolio.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Harold »

rmelvey wrote: Now, many people dismiss gold because it does not pay dividends or interest, or because it just sits there. Ironically, that is the very reason gold is such a good hedge. Dividends and interest payments are promises, and sometimes promises are broken. Gold just sits there, being gold.
But the value is in the promises/expectations of dividends/interest/company earnings. It would take every single one of those promises/expectations to go unfulfilled, for the stocks/bonds to just sit there, being stocks/bonds. With gold that's your starting point, and all you can hope for.

I have no idea whether gold is a good hedge or not, but the "promises" reasoning is quite insufficient.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Clearly_Irrational »

In isolation, gold is pretty much a pure speculation play which is probably why it gets so much hate. In addition, during times of prosperity it has a negative real return (plus an opportunity cost loss due to the fact that you could have held something else). Not all times are times of prosperity though, and when things are bad (and we have fiat currency) it seems to do quite well. If you believe that:

1) The last 40 years is representative of what will happen in the future as far as correlations are concerned
2) That at least one or more decades of your investing horizon will occur during a period of non-prosperity
3) You can live with negative performance and tracking error when things are good
4) You have a preference for loss avoidance rather than maximum expected return

then you could look at gold as having a positive effect on your portfolio as a whole and should consider some level of allocation to it based on your risk tolerance. Remember though that if you had made this decision in the late 70s you would have had to suffer through 20 years of performance drag in order to get the returns that are occurring now. Of course it still would have lowered your standard deviation and raised your sharpe ratio, but your expected return would have been less than otherwise.

In my opinion history doesn't repeat, but it does rhyme. I'd be pretty surprised if a small allocation to gold turned out to be a bad thing in the long run if it was added in a way that makes sense with your overall portfolio design. If for some reason you're thinking of holding more than 25% question your sanity, and if you're planning on more than about 10-15% and you're not going to run a Harry Browne style permanent portfolio you better have a really good explanation. For myself I'm currently investigating what I think an optimal weighting would be, but I haven't yet decided as there are a lot of factors to consider.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by startingagain »

*bump*

Was searching the forums for almost this exact question. Does anyone know if the debate has progressed any further in the last two-and-a-half years?

The scenario in which I am specifically interested is:

For a new investor with 90-100% cash position, if they decided to go lump sum instead of DCA would a x% holding in PMs be a good hedge against a market correction?
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by wastenot »

A detailed discussion of gold as part of a 4-part diversified portfolio (stocks, long term bonds, cash, gold) can be found on Craig Rowland's crawlingroad website:

http://www.crawlingroad.com/blog/2013/0 ... io-basics/

The most detailed explanation of all is in Craig Rowland and J.M. Lawson's "Permanent Portfolio" book.

Be forewarned that gold as an investment, particularly as one component of Harry Browne's Permanent Portfolio, is highly controversial on the Boglehead list.

Speaking personally, I accumulated my pre-retirement savings as an orthodox, and very grateful, age-in-bonds Boglehead, but in retirement I have switched most of my savings to the PP. In the long run, I think this will be a good move, but over the short term minor losses can and will occur. As in all aspects of investing, nothing is guaranteed.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by nisiprius »

startingagain wrote:*bump*

Was searching the forums for almost this exact question. Does anyone know if the debate has progressed any further in the last two-and-a-half years?

The scenario in which I am specifically interested is:

For a new investor with 90-100% cash position, if they decided to go lump sum instead of DCA would a x% holding in PMs be a good hedge against a market correction?
1) Nobody knows. I think an x% holding in cash would be much more certain to work.

2) When gold was rising, there was a lot of interest in it. I think it was almost entirely recency, and despite all of the talk about "diversification" it was really about "up." Part of "diversification" is the "down" part--as Larry Swedroe has said, "diversification is always working; sometimes you'll like the results and sometimes you won't." People only want the part of diversification that means "going up when other things are going down." When gold is going down, nobody wants it "for diversification."

3) Similarly, people don't mind that gold was utterly failing to act as a "stable store of value" as long as the instability consisted of "becoming more valuable."

4) I am very skeptical about negative correlation stories, claims that something consistently, reliably, persistently tends to go up when something else is going down. If that were really true, you could cancel out risk and get reward without risk.

5) I don't see anything that should have changed the credibility of something like (one of the) Permanent Portfolio(s). They are just as sound or unsound now as it ever was.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Atgard »

I don't think it's relevant to compare gold's performance when it was used as currency or under Bretton Woods when it was tied to $35 an ounce. Neither of those scenarios is in effect today, neither seems likely to happen again anytime soon, and if they do, I doubt it will come out of the clear blue sky, so people can prepare.

I also find it relevant that over time periods longer than stocks or bonds existed, gold has been valuable world-wide throughout several thousand years. So I think saying it just "sits there and does nothing" isn't particularly relevant either. It is a traded commodity with a value, and I don't think tomorrow the whole world will suddenly, after thousands of years, decide it is worthless.

So the question is, does this asset increase return or decrease risk in your portfolio? Back-tested simulations show that it does. It (a) generally goes up over time and (b) is inversely correlated with other asset classes. But of course, nobody knows anything for sure going forward.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by scone »

To the OP and startingagain. If you download the Simba spreadsheet, which is in the wiki, you can see the performance of the Permanent Portfolio, which has a gold allocation of 25%. You can also type in your own portfolio, and vary the allocation percentage to get a feel for how this thing tends to behave. Remembering that you have to rebalance to get the diversification benefit, which is very hard and something I have trouble with.

My own experience is that a small amount of gold takes your "down" standard deviation down a little, and it can increase your "up" standard deviation a little. But a large gold allocation really takes your return down a lot. I've also found that gold works better if you take it out of the stock allocation, not the bond side, and then add a very large dose of high quality bonds to the mix. It's like commodities in that respect.

I'm not entirely sure that gold is an inflation fighter per se-- it seems to be a hedge against the market fear and panic caused by supply shocks and geopolitical turmoil, such as the 70s. When the fear subsides, gold also subsides. So I would use it to soften the portfolio's drop in a crash. With gold, it's not so much that you make more money, you just lose less money than you would have without it, if that makes sense. This is valuable in itself, because if you lose 50% in a crash, it takes more than a 50% rise to get you back to even.

As to all the other questions, such as whether gold is money and how you need it in the coming Zombie Apocalypse, I personally don't give a hoot. All I care about, with any asset, is how it behaves in the context of the portfolio as a whole. Nothing else matters. So to me, gold is like putting nice shocks on a car-- it can smooth out the ride, but only if you stick with it. Good luck.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by nisiprius »

Atgard wrote:I also find it relevant that over time periods longer than stocks or bonds existed, gold has been valuable world-wide throughout several thousand years.
Except that that's not true.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Clearly_Irrational »

nisiprius wrote:
Atgard wrote:I also find it relevant that over time periods longer than stocks or bonds existed, gold has been valuable world-wide throughout several thousand years.
Except that that's not true.
There are many arguments against gold, but I don't see how this is one of them. Even if we ignore all other uses, gold coinage has been around since before the founding of the Roman Republic. Gold artifacts have been found dating back as far as the 4th Millenium BC.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by startingagain »

Thanks so much for the thought-out responses to my first post here - extremely encouraging for me!

I'm going through the information in Craig Rawling's site from wastenot's link (and scone's suggestion!). This actually clears up a lot of things for me. 25% in stocks feels extremely low (and 25% in gold quite high) but the way of thinking is not dissimilar to mine. Thanks very much.

I'm going to put together my own Portfolio Question thread now, thanks again for all the responses.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by startingagain »

My Portfolio Questions thread: http://www.bogleheads.org/forum/viewtop ... 1&t=137684 (in case you were interested).
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Call_Me_Op »

I can understand people's interest in gold. Holding "only" stocks and bonds doesn't seem like the ultimate in diversification. Both stocks and bonds can be slammed by a sharp increase in interest rates. I think it is worthwhile to consider cash as a separate asset class - even though it is technically a zero-duration bond. Then again, we have CD's, EE Bonds, I-Bonds, and real estate - all of which have unique characteristics and are worthy of consideration. I would not dismiss gold altogether, but I don't think it warrants 25% of one's portfolio either. I view it as an uncorrelated asset class, not necessarily a safe haven. Viewed this way, holding gold in physical form is not necessarily optimal.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by ralph124cf »

The costs of owning physical gold make this inconvenient for an individual investor. A gold ETF reduces the problem, but does not eliminate it.

I believe that gold mine stock mutual funds are a reasonable way to participate in the gold market. Even when the price of gold is static, a gold mine is usually profitable.

These are relatively high cost managed funds, because of the prevalence of fraud in the gold mine industry.

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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by craigr »

The conclusion I've come to over the years is that all portfolios should hold some gold. For the Permanent Portfolio traditionalists it would be 25%, but that is because that portfolio was really made with volatile assets in mind.

A traditional stock/bond portfolio I think would do well to also consider holding some gold. Is that number 25%? Probably not. But it's not 0%, it's not even 5%. It's probably at least 10% because when you need gold for protection you want to own enough for it to make a difference. At the same time you don't want to hold so much gold (or stocks, or bonds) so if it craters you get skinned alive. Gold is really an insurance asset when all else is going haywire in a portfolio. In particular in regards to bad inflation/currency crisis it can be a lifesaver. Economic situations that can be very bad for stocks, bonds and cash are usually excellent for gold. In terms of diversification then, gold can be very powerful.

A properly diversified portfolio should always own at least one dog and one high flier. The market mood can change so quickly that by owning a stinker and a winner you can always be in a position to sell high and buy low. The scariest portfolio for me to own is one in which everything is going up all the time. That means those assets can all crash at the same time as well and dish out huge losses. Gold is currently the stinker, the past 10 years it was a winner. This is just how it goes. It may continue to be a stinker, or we could finally have the Fed boost interest rates and it becomes the belle of the ball again. Nobody knows.

Overall, I think gold works well with stocks, bonds, and cash to make a well rounded asset allocation and should be on the short-list of assets to hold even if an investor isn't a particular fan of it. I think there is enough evidence and world events to show that it can be a useful asset to have under certain markets.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Call_Me_Op »

Craig,

Thanks for chiming-in. For the person who wants to hold (say) 10%-15% in gold as a diversifier, what do you feel are the acceptable form(s) for the gold (physical, ETF, CEF, etc)? Perhaps all of the above?
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by craigr »

Call_Me_Op wrote:Craig,

Thanks for chiming-in. For the person who wants to hold (say) 10%-15% in gold as a diversifier, what do you feel are the acceptable form(s) for the gold (physical, ETF, CEF, etc)? Perhaps all of the above?
It probably is all of the above for various reasons. ETFs are easiest to rebalance/liquidate but in an emergency may be not as robust as other methods. Physical gold stored off-shore for geographic diversification is also a good idea for serious problems in the country where you live.
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Re: Gold vs. Bonds as an Asset Allocation Hedge

Post by Browser »

What do you want your "asset allocation hedge" to do for you? Are you interested in trying to improve your long term returns or are you mainly interested in trying to reduce short-term portfolio drawdowns? Assets such as gold have shown themselves to be helpful at reducing "left tail" risk; i.e., portfolio drawdowns. However, the price you pay for this insurance is reducing "right tail" gains; i.e., long term compound returns -- no free lunch. For me, the reason to try to reduce left tail risk is the risk that you'll get scared out by a bear market and bail out at the wrong time. You have to ask yourself how much portfolio loss you can realistically tolerate and not panic. If you look at the annual returns of a portfolio of 50% stocks/ 50% intermediate treasurys since 1972, the worst annual losses were about 11% in 1974 and 12% in 2008. The max single point drawdown in 2008 was about 18%. If that would have been too much for you to handle, then it might be a good idea to either reduce your stock allocation somewhat in favor in either bonds or gold. An allocation of 75% treasurys, 25% stocks had a max single point drawdown of about 8% in 2008 and gained about 1% for the year. The PP had a max single point drawdown of about 6% in 2008 and lost about 1.5% for the year - quite similar. So either the PP for the 25/75 would have had tolerable losses in 2008 for most investors.

If you consider the upside, you get a higher compound return for the PP than the 25/75 allocation for the period 1972-2013; however, if you eliminate just the first two years (1972-73) the return is about the same, with similar annualized volatility and risk-adjusted return. That seems reasonable to do, since owning gold was still actually illegal for U.S. citizens until 1975. It's unlikely that many investors would have actually owned it then. Gold was very difficult for investors to own in significant amounts until the evolution gold ETFs, and there were very high costs associated with buying it and storing it which are seldom figured into the returns. Additionally, there is usually a premium associated with owning illiquid investments such as physical gold, and that premium has likely disappeared now that gold can be easily bought and traded in the form of gold ETFs.

Since holding either gold or a large allocation to treasurys are both "left tail hedging" strategies it's not surprising that the performance of both is pretty similar. Having 75% in treasurys and 25% in stocks exemplifies Swedroe's left-tail portfolio strategy, which holds about 30% in diversified smallcap value stocks and 70% in bonds.

I own a small allocation to gold, but frankly I think it's out of habit rather than rational argument. The points I made above represent the "rational argument" aspect and I've convinced myself that it's probably better to just hold a larger allocation to intermediate treasurys. Can I imagine scenarios in which it would be nice to be owning some gold? Well, yes I can imagine scenarios in which both stocks and U.S. treasury bonds might not do well. The last time that happened was during the 1970s and we could see that again. So, I hold a little gold insurance just so I don't feel totally stupid if that happens but it's probably more of a psychological crutch than anything else. People have lost a lot of money by hedging for the perfect storms that never show up or only show up after a long time. The nature of making money by investing is that you have to take some risks in order to do it. No free lunch.
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