Achieving highly risk-adjusted returns for your investments is the most confusing question concerning a money-saver. Adding assets to one’s portfolio and their percentages is a big concern. Individuals are mainly searching for high relative returns by comparing the risks they take. The profit or potential profit from an investment that takes into account the level of risk that must be taken in order to accomplish it is called a risk-adjusted return.
Financial markets and books assume that investors are risk-averse by nature, but the degree or level of this aversion differs from one person to another. “Don’t put your eggs in one basket” is a common rule among widely-ranging investors in markets, and it was the basis for their thoughts to avoid risks.
The financial idea of portfolio diversification refers to spreading your investments over a variety of asset classes to reduce the overall risk of a portfolio.
The question that will soon arise is, “What is the best-balanced portfolio to attain satisfying returns for individuals? Stated differently, what is the proportion of stocks and bonds in a person’s portfolio? Is it necessary to add gold? If so, by what percentage?
Portfolio managers will always suggest increasing the ratio of bonds (risk-free) to stocks if an investor is more risk-averse, and vice versa. “Gold” is a “rule of thumb” for any portfolio, they say, regardless of one’s level of risk aversion. Excellent, but why?
Why should one consider adding gold to their portfolio?
There are many reasons why gold is a perfect diversification asset as discussed below:
1. Gold helps you manage and mitigate the overall risk of your portfolio
Including gold in your investment mix can help you manage your risks in different ways:
- Because of the history of gold as a safe-haven asset
Gold has a long history of acting as a safe-haven asset, which encourages investors to flock to gold, especially during economic turmoil. Volatility was the main feature of stocks in those times, while gold was inclined to hold its value or even increase. Mitigating the risks of stocks or the volatility during economic uncertainty is one of the important reasons one should hold gold in his investment portfolio. Historically, gold has shown resilience after traditional assets faced major declines. For example, during the 2008 financial crisis, though stock markets plunged, gold prices peaked. - Due to gold’s low or negative correlation with most other assets
Modern Portfolio Theory (MPT) in 1952 shows how to achieve the best return by merging assets with a negative relationship to each other. Gold has a very low or negative correlation with most other investment assets, so it typically moves in a different direction than shares (Graph #1). This is a rare quality for an asset, meaning that gold can reduce the risk of a portfolio. Financially speaking, gold helps increase the portfolio returns’ quality, meaning that you can earn a similar return with less risk. Gold offers portfolio diversification and is regularly correlated with the equity market through risk-on periods, while it has an inverse correlation during periods of tension. Among the majority of financial market hedges, gold has a special quality. In the past, it has demonstrated the ability to maintain its purchasing power and provide portfolio insurance when necessary. It will continue to gain from the massive amount of government debt with negative yields.
Graph 1: Correlations of gold to other assets
Regardless of investing horizon or risk tolerance, gold is a major portfolio diversifier. Given that bonds and shares are trending in the same direction, it is now even more crucial for “growth-focused investors” than it was previously. A stock-buying technique known as “growth investing strategy” looks for companies that are predicted to grow faster than average in their sector or the overall market.
But how is negative or low correlation good in a portfolio?
Negative correlation is one of the core ideas of “portfolio diversification.” It may be possible for the investor to reduce the overall risk of his portfolio by including assets that are negatively connected. The performance of the portfolio is balanced and the likelihood of losses is decreased when one asset or sector performs poorly while another may be performing well.
2. Gold helps you enhance or increase your returns taking the risk factor into consideration
The chance to gain wealth appreciation from owning gold in your portfolio. As per the World Gold Council, the price of gold surged from approximately $1,610 per ounce to over $1,887 per ounce between the years 2000 and 2020.
Figure 1: Advantages of having gold in a portfolio
The following query, therefore, will require an answer, and the subsequent line of reasoning will be:
What proportion of gold should thereafter be added?
Answering this question varies from one individual to another depending on many factors, like age, risk tolerance, preference concerning portfolio composition, etc. For example, an investor in his 20s could prefer to invest more in stocks than other less risky assets. Yet another one in his 60s might look for safer assets like gold and bonds, even if the trend of gold prices is decreasing in that period.
Generally speaking, if one considers gold in his portfolio, he might want it to be a specified percentage rather than the whole pie; otherwise, he is not diversifying. Helping to answer this question, it became a rule of thumb in financial markets to consider investing 5–10% of your portfolio in gold.
This might be a bit different in countries in the MENA region, as the percentage should increase to an average of 10–20%. A recent study by the Economic Research Forum (ERF) in November 2021 titled “Hedging the Risks of MENA Stock Markets with Gold: Evidence from the Spectral Approach” has concluded that the usage of gold in portfolios can decrease the variance (variability) or overall risks by more than 70% for the stock market index of Egypt, Dubai, Jordan, and Saudi Arabia.
The Egyptian businessman Naguib Sawiris has presented his view of assigning more to gold with an average of 20% of an investor’s portfolio, especially in an environment of high inflation. In light of the current crises, global tensions, and the outbreak of wars, Sawiris recently announced, “I have chosen to direct 40–50% of the money funds to the yellow metal.”
We may also find an answer to this question from the WGC, which demonstrates how gold enhances risk-adjusted returns across portfolio building. According to its data, investors denominated in US dollars can significantly improve the performance of a well-diversified portfolio by allocating up to 10% to gold (Graph #2).
Graph 2: Optimal Allocation of Gold across Different Portfolios’ Mix
The following points could be summarized from the above graph:
• Portfolio mix of 20% stocks, commodities, REITs, and gold, and 60% cash and bonds, the best gold percentage in this mix that provides the optimal risk-adjusted return will be 2.6%.
• For individuals who prefer the mix of 30/70 and are considering allocating from 2.7% to 3.9% of gold in this mix, the optimal percentage of gold that provides the highest risk-adjusted return will be 3.2%.
• 9% is the optimal allocation of gold among the portfolios of the 60/40 mix.
• More risk-lovers’ investors who are assigning 60% of their mix to stocks, from this percentage of 4.5% to 9.1%, the optimal gold percentage was 7.5%, according to the WGC analysis.
• Finally, for investors who are assigning gold a percentage ranging from 5.3–10% in the 80/20 portfolio mix, the optimal percent will be 9% of gold which produces the highest risk-adjusted returns.
• And generally speaking, the higher the risk in a portfolio (increasing risky assets in the mix as stocks), the higher the required percentage of gold to balance this risk.
In any given portfolio mix, gold acts as a good diversifier across various risky assets and between varying risk tolerance and preference levels. Because of the potential capital gain from a long-term increase in the price of gold, it contributes to better returns. As a general rule, investors should allocate between 10 and 20 percent of their portfolio to gold. The higher the volatility or riskier the assets in the portfolio, the larger the allocation of gold to mitigate the risk.