I’ve been investing for more than two decades and managing my family’s investments for nearly half that time. Gold has never been part of our portfolio. We never gave it serious consideration. Things have fundamentally changed recently.
On a personal level, our portfolio is now several multiples of what it was a decade ago when we developed our plan. Our ability to work and save to rebuild it is less certain than it was just a few months ago. Limiting volatility has become much more important to us.
On an investment level, stock valuations remain high by historic standards despite record unemployment and an even more uncertain than usual economic future due to the COVID-19 pandemic. Interest rates are at historic lows.
Stocks and bonds are both looking unattractive. I’ve been considering adding gold to diversify our portfolio.
Why Gold, Why Now?
I recommend everyone have a written investment policy statement. In ours, Kim and I outlined a method for making changes to our portfolio to avoid acting on emotion.
We wrote, “We will adjust our allocation only when we mutually agree and only when something fundamentally changes to the point that it would be beneficial to do so. Examples would be shifting to a more conservative allocation as we meet investment goals, exiting an asset class if it no longer meets our investing objectives, or adding asset classes if they become available in a cost efficient way as we combine accounts over time.”
That sounded great on paper when we wrote it. In practice, considering an asset that we’ve never previously considered holding while the pandemic and its massive economic uncertainty looms feels a lot like letting emotion get the better of us.
Before taking action, it was time for reflection. We started by reviewing why we haven’t held gold up until now.
Downsides of Gold
Gold is not an investment. It is speculation. Physical gold doesn’t generate any income. You can only make money from gold if you sell it for more than you bought it. Don’t forget to account for transaction and storage fees.
A chart of inflation adjusted gold prices shows this is not a promising proposition. You could have bought gold at its most recent peak in September 2011 for nearly $1,900 per ounce.
That ounce is worth about $1,700 after holding it for nearly a decade. This is before factoring in expenses. Anyone considering gold should read the last paragraph from the post Should I Buy Gold?, written in December 2011.
Buying physical gold creates transaction fees. You may have to rent a safe deposit box or purchase a safe to store your gold.
You can limit transaction and storage fees and improve liquidity by holding gold in an ETF. Two of the most popular ETFs are GLD and IAU. They carry expense ratios of .4% and .25% respectively. While not egregious, these fees are approximately 2.5 to 4 times greater than the average of the index funds we currently hold.
Some people choose to invest in companies or concentrated funds of companies that mine gold and other precious metals rather than the metals themselves. As with any equity investment, this creates potential cash flow from dividends in addition to the possibility of price appreciation. But investing in a few companies or a small sector of the market also adds significant cost and risk compared to a broad market index investing approach.
Reviewing the downsides of owning gold reminds me why we didn’t initially choose to include it in our portfolio. This leads to my next question.
What’s Actually Changed?
When we built our portfolio, we chose to allocate 80% of our portfolio to stocks. At the time, we were saving and building wealth.
We were comfortable with the volatility of that aggressive allocation. With low interest rates, I questioned whether we were actually too conservative and I only kept the small amount of bonds and cash to appease Kim who is more conservative than me.
We assumed we’d shift some of our stocks to bonds as our portfolio grew, we transitioned to early retirement, and bond yields became more attractive.
But yields never became more attractive. We also ended up earning more money than we were anticipating as we began our transition. So we let things ride.
In 2019, the markets had an amazing year. I started to think about taking some risk off the table. At the time, the nominal yield on 10 year treasuries was less than 2% and the real yield was essentially 0%.
Putting more money into bonds with those low yields was unappealing. Our income situation continued to look strong. So we didn’t make any changes to our portfolio.
A Punch To The Face
When the coronavirus hit in March, I learned three things:
- I am not as comfortable as I assumed with market volatility. Watching our stock heavy portfolio plummet with the market, sometimes by 10+% in a day, was gut wrenching.
- As much as I despised the volatility of stocks, it was easy to follow our plan to sell bonds to buy even more stocks. Buying bonds didn’t make sense for us last December. We felt fortunate to sell some at a profit after rates dropped in March to rebalance our portfolio in April.
- Things can change overnight. My book sales and blog advertising revenue looked strong in February. They fell off a cliff in March. Our contingency to use our mother-in-law suite as a short term rental to generate income evaporated simultaneously, at least for the foreseeable future. My ability to go back to work as a physical therapist became unlikely. My wife’s work still seems stable, but the entire economy is more vulnerable than it was six months ago.
I continue to look for ways to limit volatility in our portfolio while maintaining opportunities for growth. A traditional approach of shifting our allocation away from stocks and towards bonds would likely meet the first objective, but at the expense of the second given extremely low interest rates.
So I’ve been exploring alternative asset classes that are not highly correlated to stocks. One option is real estate. We own our home outright, which gives us planning options external to our portfolio.
We’ve also already allocated 10% of our portfolio to real estate investment trusts (REITs). Their performance and volatility are similar enough to stocks that we consider them part of our 80% equity allocation. We don’t want to increase our REIT allocation.
Adding rental real estate is another option. We’ve tried our hand as landlords, renting our current residence for a year before moving in. I’ve continued to explore using rental real estate to produce more retirement income.
However, the low interest rates that make bonds unattractive and are contributing to high stock valuations are also helping inflate housing prices. This makes buying a quality investment property challenging in our area, as it is in many others.
Physical real estate also doesn’t fit with our otherwise passive investment approach. So I’ve decided to take a closer look at the impact of gold on a portfolio.
Gold In A Portfolio
Several well known portfolios advocate for a large percentage of a portfolio to be allocated to gold (or a combination of gold and other commodities). Examples are Harry Brown’s Permanent Portfolio, Ray Dalio’s All Seasons Portfolio, and the Golden Butterfly Portfolio.
They all have reasonable long-term returns with lower volatility than my portfolio. I have two major reservations with all of them:
- Each portfolio allocates a substantial portion of the portfolio to gold or other commodities (15-25%). I understand this strategy. But it isn’t something I feel comfortable with. A key element to being a successful investor is not picking the perfect asset allocation, but choosing a “good enough” allocation you’ll stick with for the long haul. I doubt I’d have the conviction to stick with these strategies that I don’t fundamentally believe in.
- These portfolios all have a large allocation to bonds (40-55%). With interest rates at extreme lows, I have little confidence that future returns will match the back tested data of recent decades.
As I was researching for an article on rebalancing a few months ago, I read William Bernstein’s The Rebalancing Bonus: Theory and Practice. Bernstein wrote the following:
“The portfolio characteristics of precious metals equity are unique; very low long term return, very high return variance, and near zero correlation with most other asset classes…Thus, not only is the systematic risk of precious metals stocks much lower than its stand alone risk, but its rebalanced portfolio return is much higher than its observed stand alone long term return.”
The Impact of Gold on a Portfolio
Bernstein’s statement got my attention and sent me back down the gold rabbit hole. After doing a lot of reading on gold, I compared four portfolios at Portfolio Charts:
- Our current 80% equity/ 20% bond portfolio. Equities were represented by 30% US Total Market, 10% US REIT, 10% US Small Cap Value, 10% Europe, 10% Japan, 10% Emerging Markets. Bonds were represented by 15% intermediate-term Treasuries, 5% T-Bills.
- A 60% equity/ 40% bond portfolio. Equities were represented by 26% US Total Market, 10% US REIT, 6% US Small Cap Value, 6% Europe, 6% Japan, 6% Emerging Markets. Bonds were represented by 35% intermediate-term Treasuries, 5% T-Bills.
- A portfolio of 75% equities/ 20% Bonds/ 5% Gold. Equities were represented by 29% US Total Market, 10% US REIT, 9% US Small Cap Value, 9% Europe, 9% Japan, 9% Emerging Markets. Bonds were represented by 15% intermediate-term Treasuries, 5% T-Bills.
- 80% equities/ 20% Gold. Equities were the same as in portfolio 1. Gold was substituted for the bond portion of the portfolio.
I summarized the impact of average return (Return), the percentage of years the portfolio lost money (% Losing Years), standard deviation (SD), and the maximum single year drawdown over the past 50 years (1970-present) in the table below.
|% Losing Years
Making Sense of the Numbers
The first thing I noticed in the chart is that all three alternative portfolios substantially decreased the worst single year drawdown from our current portfolio. Both of the alternative portfolios with bonds decreased the standard deviation of the portfolio. Our goal is to protect our principle and decrease volatility, so this was interesting.
I didn’t place a lot of emphasis on the absolute return numbers. The Portfolio Charts tool looks at back tested data over the past 50 years. The past 40 of those years consisted of a historic bull run for bonds, as interest rates have fallen from all time highs to all time lows. I anticipate low interest rates will mean lower returns going forward.
Ben Carlson recently wrote a fascinating article on periods of low bond returns in the past. Of particular interest were four consecutive decades of negative real returns from the 1940s through the 1970s that preceded the strong bond returns from the 1980s to the 2010s.
Even in better times for bonds in recent decades, the 60/40 portfolio returned at least a full percent less than any of the other three portfolios. The 60/40 portfolios’ redeeming quality for those drawing from the portfolio was having the lowest standard deviation.
The 80/20 stock/gold portfolio was compelling because it added nearly 2% in annual return compared to the more conventional 60/40 stock/bond portfolio. They delivered these returns with identical 32% maximal drawdowns.
However, this portfolio produced the greatest percent of losing years and largest standard deviation of any of the portfolios. I would be uncomfortable allocating 20% of our portfolio to speculative investments to start. It would be incredibly hard to stick with a plan that I don’t fully believe in through a stretch of rough years.
The Sweet Spot?
The most compelling portfolio given our objectives was to shave 5% from our equity and allocate those funds to gold. That backtested portfolio delivered near identical returns to our current portfolio. It did so while shaving 1% from the standard deviation and chopping 7% from the maximum single year drawdown.
More importantly, this approach requires making only a small change from our current investing philosophy. It should be relatively easy to stay the course and stick to the plan during periods of underperformance, which are inevitable for any portfolio.
As we’ve considered making changes from our current 80/20 stock/bond portfolio to a 75/20/5 stock/bond/gold portfolio, one substantial challenge remained…
The Challenge of Market Timing
I can sum up both articles in one sentence: Time in the market is more important than timing the market. I always prefer to control the things I can control, putting my money to work where it is earning dividends and interest, rather than worrying about things I can’t control, future share prices.
However, the fundamentals of gold are different than those of stocks and bonds. The reason for adding gold to our portfolio is to capitalize on its high volatility and low correlation with our other investments. It is a speculative investment that is dependent on being able to buy it low and sell it high when rebalancing.
Had we made the moves that we’re considering at the end of 2019, rather than the middle of 2020, we’d have been feeling pretty good about ourselves. The price of an ounce of gold has jumped from $1,570 in early January to $1,740 in early June, an increase of about 11%.
Over that same period all of the stock index funds we invest in are down for the year. Our worst performing fund, Vanguard’s Small Cap Value Index fund, is down about 14%. This is exactly the opposite of the “buy low, sell high” mantra that guides successful investors.
So does it make sense to make a long term shift in our portfolio? If so, when and how should we do it?
Going for Gold
We’ve decided to allocate a small amount of our portfolio to gold. Our target allocation will be 5% of the portfolio.
Our reason for buying gold is to utilize the volatility and low-correlation with our other asset classes. The goal is to improve long-term returns while decreasing portfolio volatility through rebalancing. For those reasons, we chose to own gold in an ETF rather than purchasing physical gold. We chose iShares Gold Trust ETF (IAU).
We’re still not 100% sure how we’re going to transition from stocks to gold. Looking at the current price of gold, we’re certainly in no hurry to go all in today. We decided a dollar cost averaging approach away from our stocks and towards gold makes the most sense.
Looking at our portfolio, I was shocked to see that the Vanguard Total Stock Market Index (VTSAX) was almost back to even for the year as of Friday, June 5th. We’re tens of thousands of dollars in the black due to the rapid price run up since rebalancing just two months earlier.
So we started by selling off approximately 1% of our total portfolio from VTSAX shares. We’ll gradually sell off a portion of our other equity funds over the next year and use the proceeds to start making monthly gold purchases until we reach our target allocation.
Hopefully, adding a little gold to our portfolio will improve our risk adjusted returns over the ensuing decades. In a worst case scenario, we’re speculating with a small portion of our portfolio while maintaining our core principles with the vast majority of our investments.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to firstname.lastname@example.org. Financial planning inquiries can be sent to email@example.com]
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