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Gold and Its Role In a Portfolio

Gold stole the show from Bitcoin and other financial assets as its parabolic move higher in 2020 took many by surprise. What is interesting is that the move higher in gold started in the summer of 2019 – many months before the coronavirus pandemic to reach the Western world. 

Why would anyone invest in gold, and how is it that the curious yellow metal attracts so much interest from the investment community? Maybe because it is the only form of money humankind knows that survived for thousands and thousands of years.

Why Adding Gold to a Portfolio?

By definition, a portfolio contains two or more assets. The degree of correlation between the assets defines the riskiness of the portfolio.

The principle applies to all kinds of portfolios. People automatically assume that portfolios refer to stocks only, but similar principles can be applied to assets belonging to the different markets. For example, an investor may have a portfolio of currencies or currency exchange rate and use the diversification principles to avoid unnecessary exposure.

Coming back to the portfolio, the idea is to add a new asset to a portfolio that has a lower correlation with the actual asset or assets. If not, the asset should not be added because it increases the risk. In the currency market, it is like buying the EURUSD and then adding the GBPUSD or AUDUSD to the mix. Because the three assets are positively correlated, the portfolio would be better off in the long term without adding the two new assets.

One way to improve the performance of a portfolio that has two or more risky assets is to add a risk-free asset. Think here of a government bond, as the U.S. Treasury. It has a zero correlation with the portfolio and zero risk and thus improves the portfolio’s performance.

Another way is to add assets that have a correlation below 0.5 or above -0.5. A negative correlation means that the asset moves in the opposite direction with the current assets part of the portfolio.

This is where investing in gold makes sense. By adding gold to a portfolio, an investor obtains diversification benefits while protecting the value of the current assets part of the portfolio. For this reason, investors allocate only a small part of the portfolio to an alternative investment like gold – typically a few percentages.

The aim is to obtain protection against inflation without affecting the portfolio’s potential return.

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