How Much Gold Is Needed to Reduce Portfolio Risk?Posted on — Leave a comment
Conventional wisdom holds that including some commodities, like gold, in your portfolio reduces downside risk. Research supports this theory by illustrating that gold reduces volatility due to its lower correlation to stocks. However, recent work from Sweden reveals a surprising detail about this concept. Researchers at the Umea School of Business discovered that the optimal commodity weighting in a portfolio isn’t what most expect.
The authors used a series of statistical models relying on measurements like deviation, variation, and regression to understand how different commodity weightings reduce risk. The authors approached the study from a global perspective. In addition to the S&P 500 index, the researchers examined the Nikkei 225, which is more appropriate for Japanese investors. Other indices included in the study like the DAX 30 and Sensex relate to German and Indian investors respectively. Despite the variety of indexes used, the optimal commodity weighting was surprising across the board.
The results “imply that adding at least 49% commodity index would improve the overall performance of the portfolios.” This “improved performance” is reduced volatility and therefore lower risk. The data studied covered the period starting in January of 1997 and ending in March of 2017.
Why is this finding unexpected? Common advice suggests allocating as little as 5 – 10% towards commodities in a portfolio. For example, in a recent Charles Schwab whitepaper analysts recommended committing just 1-5% of a portfolio to precious metals. “Our results are not in line with the experts’ suggestions since we get considerably high proportions of commodities in investors’ portfolios,” explain the researchers.
Additionally, the 49% weighting is the lowest optimal amount discovered among the indices. When using the Hang Seng Hong Kong index, the researchers found the optimal weighting was a whopping 69%.
It’s important to note that these findings are relative to a portfolio consisting of just two asset classes, stocks, and commodities. Therefore, an optimal commodity weighting of 49% means holding the balance of the portfolio (51%) in stocks. The average optimal commodity index weighting across all indices was 60.5% with a balance of 39.5% in stocks.
The researchers went further and explored why the optimal weighting was so high. This question brought them to gold which “has a volatility close to the lowest one of the stock indices at same time with a noticeably high return, for all time frequencies.” All other commodities studied had higher volatilities. This finding is significant given that the commodity index used in the analysis consisted of 24 components including platinum, sugar, and cotton.
Do these results mean investors should allocate nearly half of their portfolio to gold? Perhaps not, however, the research does give reason to reconsider how powerful gold can be as part of a risk management tool in portfolio design. Gold offers not only the opportunity for substantial long-term asset growth but also stability when it’s needed most. These research results come at a critical time. Geopolitical tensions are rising, volatility is growing, and U.S. policy is an uncertain as ever.