The price of gold reached a new high during the COVID-19 pandemic. It crossed the $2,000 level for the first time in the summer of 2000, rewarding traditional investors. Is gold warranted to protect the portfolio?
Gold is an alternative investment. As a commodity, gold was historically used as a hedge against inflation. Inflation is on the rise throughout the world as a result of the COVID-19 pandemic. Governments, as well as central banks, have gone all in when it came to spending to protect economies and households.
The ability of a central bank to fight rising inflation depends on its credibility – how it is viewed and perceived by economic agents and households. In the investing world, used to hedge risks, gold plays the role of diversifying the portfolio due to its reduced correlation with traditional financial assets.
Gold As An Effective Portfolio Diversifier
Gold brings diversification benefits to a portfolio because of its low correlation with traditional asset classes. Such diversification reduces volatility, but it also increases risk-adjusted rates.
The typical investing portfolio consists of 60% equities and 40% stocks. But in a world of rising total credit market debt, the risk is that inflation will start rising even in the developed economies, as the monetary base increased exponentially during the last two crises – the 2008-2009 great financial vrisis and the economic recession triggered by the COVID-19 pandemic.
Hence, gold’s role in the portfolio makes sense in a world of higher debt levels, rising inflation, and monetary base expansion. Studies show that allocating between 5% and 10% to gold in a stocks/bonds portfolio will enhance gains and decrease volatility over time.
For instance, a 50-40-10 portfolio would have delivered better performance than the traditional 60-40 portfolio in the last two decades, where 10 refers to investing 10% of the portfolio in gold.
The idea behind adding gold to the traditional 60-40 portfolio is that the equity risk declines significantly. In a day when equities trade at record highs, and many fear a downright correction, perhaps it is wiser to add gold rather than reducing the equity exposure. That way, investors protect against higher inflation too.