Striking Portfolio Balance with Gold Stocks

In the first of a series of analysis pieces by senior investment figures, Frank
Holmes, CEO and Chief Investment Officer at U.S. Global Investors, looks at how
gold can work to balance your investment portfolio. Gold stocks have
historically ranked among some of the most volatile asset classes. Over any
given one-year period, it is a non-event for gold stocks to move plus or minus
38 percent. This DNA of volatility is about three times that of gold bullion,
which carries an annual volatility around 13 percent. Despite this volatility,
our research shows that investors can use gold stocks to enhance returns without
adding risk to the portfolio. In 1989, Wharton School finance professor Jeffrey
Jaffe completed an academic study that illustrated the effects of portfolio
diversification into gold stocks. Jaffe's original study covered the period
from September 1971, just after President Nixon ended convertibility between
gold and the dollar, to June 1987. During Jaffe's study period, the average
monthly return for the S&P 500 Index was 0.89 percent. Gold stocks, as measured
by the Toronto Stock Exchange Gold and Precious Minerals Total Return Index,
converted to U.S. dollars, performed considerably better, returning an average
monthly return of 1.42 percent. On the risk side, gold stocks had greater
volatility (measured by standard deviation) than the S&P 500. But Jaffe found
that, because of their low correlation to U.S. stocks, adding a small percentage
of gold-related assets to a diversified portfolio slightly reduced overall risk.
Here is an updated version of Jaffe's results. To find an optimal portfolio
allocation between gold stocks and the S&P 500, the efficient frontier plots
different portfolios, ranging from a 100 percent allocation to U.S. stocks (the
S&P 500) and no allocation to gold stocks, and gradually increases the share of
gold stocks while decreasing the allocation to U.S. equities. Assuming an
investor rebalanced annually, our research found that a portfolio holding an 85
percent allocation to the S&P 500 and a 15 percent allocation to gold equities*
had essentially the same volatility as the S&P 500 (horizontal axis) but
delivered a higher return (vertical axis). In other words, the addition of a
small allocation to gold stocks increased portfolio returns with no increase in
the portfolio's volatility. Between September 1971 and November 2011, the S&P
500 averaged a 9.69 percent annual return. A 15 percent allocation to gold
equities and an 85 percent allocation to U.S. stocks, with annual rebalancing to
maintain the allocations, would have yielded, on average, an additional 0.82
percent per year. How much is 0.82 percent per year? Let's use a hypothetical
$100 investment as an illustration. A $100 investment in gold stocks in 1971
would have grown to nearly $5,100 at the end of November 2011, while the same
amount in the S&P 500 would be worth about $4,800. But look what happens when
you combine the two. Assuming the same average annual returns since 1971 and
annual rebalancing over 40 years, a hypothetical $100 investment in a portfolio
with 15 percent gold stocks would be worth about $6,600 . That is 37 percent
greater than the $4,800 for the portfolio solely invested in the S&P 500, while
adding virtually zero risk. U.S. Global Investors consistently suggests
allocating up to 10 percent gold in a portfolio, so we also looked at returns
for investors at that level. In dollar terms, a hypothetical $100 investment in
the 90-10 portfolio would grow to $6,022 over the ensuing 40 years (assuming
annual rebalancing), compared to $4,820 for the portfolio solely invested in the
S&P 500. And when you look at the efficient frontier in the chart, a portfolio
with a 10 percent weighting of gold stocks and a 90 percent allocation to the
S&P 500 has also historically increased return with no additional volatility.
More than two decades and many ups and downs have passed since Jaffe published
his study, but our follow-up research shows that the relationship among gold,
outsized returns and volatility has remained consistent through the past four
decades. If you haven't already completed your annual portfolio rebalancing,
this may be an opportune time recalibrate your portfolio with gold stocks. *Time
series for Toronto Gold & Precious Minerals Index is a composite of this
index's returns from 1970 to 2000.