Should You Add Gold to Your Portfolio?

With the news that gold surged to a new record yesterday, inevitably I'll get questions about adding gold to portfolios. Gold has a low correlation to both stocks and bonds, which is why it can help diversify a portfolio. Today, I'll examine whether gold or a more broadly diversified basket of commodities is a better diversifier.

As I noted in my book The Only Guide You'll Ever Need for the Right Financial Plan, gold has served as a store of value over the very long term, but it has still gone through very long periods where it lost value in real terms. For example, gold traded at $850 per ounce in 1980, then traded at around $900 per ounce at the end of 2009 -- 29 years later. During this time, inflation averaged 3.55 percent per year. To further illustrate this point, at the beginning of 2003 gold was trading at $343 per ounce. From the period of 1970-2002, inflation averaged 3.84 percent per year. For this reason, gold can't be a good inflation hedge except perhaps over an investment horizon far longer than that of the typical investor.

The academic community is split on whether a broadly diversified basket of commodities is a good inflation hedge. On the one hand, Dartmouth professor Ken French argues that commodities (and gold) aren't a good hedge of inflation. On the other hand, Gary Gorton and K. Geert Rouwenhorst argue that commodities can hedge inflation. My position is that a broad basket of commodities provide more inflation protection than gold. Commodities, as an input into production of goods, are a source of inflation, while gold isn't.

A positive note for gold is that it has low correlations with stocks and bonds, so it theoretically should act as a great diversifier. However, the same is true of commodities in general. Kevin Grogan, who co-authored Right Financial Plan with me, examined the impacts of adding gold and adding commodities to a diversified portfolio.

Below are three portfolios*, and their returns 1970 through 2010:

	Annualized Return	Standard Deviation	Sharpe Ratio
Diversified Portfolio	11.36%	12.63%	0.515
Diversified Portfolio with Commodities	11.32%	11.79%	0.541
Diversified Portfolio with Gold	11.29%	11.71%	0.541

When you look at the full period from 1970-2010, it appears as if gold is as good of a diversifier as commodities. When looking at these numbers, it's important to note that the last six years have seen double digit positive returns for gold. If you were to run these same numbers thru 2004, the portfolio with commodities would have a higher return and lower standard deviation than the portfolio with gold.

1970-2004	Annualized Return	Standard Deviation	Sharpe Ratio
Diversified Portfolio	12.42%	11.33%	0.603
Diversified Portfolio with Commodities	12.39%	10.39%	0.647
Diversified Portfolio with Gold	12.22%	10.45%	0.626

If an investor standing in early 2005 saw these results, they likely would've chosen commodities over gold. It's important not to place too much weight on the most recent returns. The past few years have been very good for investing in gold, and this has impacted the long-term annualized returns. When you look at the evidence from 1970-2010, you can see the diversification benefits of both gold and commodity futures. A case can be made to add a small allocation to either, but I believe the case is stronger to include a diversified basket of commodities rather than gold alone.

* The diversified portfolio without commodities or gold comprise the following indexes: 7.5% S&P 500 Index, 7.5% CRSP 9-10 Index, 7.5% Fama-French US Small-Cap Value Index, 7.5% Fama-French US Large-Cap Value Index, 15% Fama-French International Value Index, 15% DFA International Small-Cap Index and 40% One-Year US Treasury Note Index.

Portfolios containing commodities or gold are comprised as follows: 7% S&P 500 Index, 7% CRSP 9-10 Index, 7% Fama-French US Small-Cap Value Index, 7% Fama-French US Large-Cap Value Index, 14% Fama-French International Value Index, 14% DFA International Small-Cap Index, 40% One-Year US Treasury Note Index and 4% of either S&P GSCI or the physical returns of gold.
More on MoneyWatch:
Why Concerns About Diversification Are Overblown 3 Problems with Investing in International Real Estate John Bogle: Can His Son Beat the Market? Can You Find the Future Winners? Quest for Alpha: 10 Rules for Being a Successful Investor
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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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