20% Gold Allocation Has Best Risk/Reward Ratio [STUDY]

by Michael Ide

Gold can be a particularly controversial asset, with some people claiming that it should be a major part of every portfolio and others pointing out that the mining operations continue operating at a loss even as prices drop, and that the time for defensive measures has passed. A new report from David Varadi, David Wismer, and Jerry C. Wagner at Flexible Plan Investments Ltd. comes squarely down in the former camp with the conclusion that a balanced portfolio should allocate 20% to gold to maximize risk-adjusted returns.

Gold can be a great way to hedge

“Quantitative analysis of gold in different economic and market regimes demonstrates that gold has been valuable for investors as both an alternative source of return and also as a hedge,” they write. “Contrary to conventional wisdom, the study finds that over the period from 1973-present, the efficient allocations to gold for a typical balanced investor ranged from 5% to 45% depending on the desired risk preference. Furthermore, the optimal allocation was 20% which produced higher risk-adjusted returns than any other portfolio.”

The report starts by establishing that over the last forty years gold has been the second best performing asset class overall, behind equities and ahead of Treasury bonds, and that it acts as a hedge against currencies and equities because it is negatively correlated with other assets.

But what’s most interesting is that the report calculates the risk-adjusted rate of return for balanced portfolios with different amounts of gold allocations (balanced in this case means the remainder of the portfolio is split 60/40 equities and bonds).

Individual investors take note

Varadi, Wismer and Wagner are taking a long view on gold investments, so they aren’t necessarily saying that people should start investing right now (and many analysts would advise against it for the time being), but they do think most people are underinvested in gold and that the “5% rule of thumb” as they call isn’t based on solid evidence. For portfolio managers who have already formed an opinion, the report probably isn’t going to change any minds, but individual investors for whom gold is simply off the radar may be missing out on an easy way to improve their returns.