Gold in your portfolio – how much should you invest in gold?
Retail investors who have decided to invest into gold face the question of how much to invest in gold. Since gold investments also carry some risks, i.e. a potential partial loss of value, gold should not be the only investment in any investor’s portfolio.
Financial theory suggests that gold investments may be held for basically three different purposes: Diversification, hedging or speculation. Depending on an individual investor’s objectives and assumptions, the optimal portion of a portfolio to invest in gold will vary.
Diversifying with gold assets
Diversification in finance means to allocate funds to various asset classes and investments. The diversification of a portfolio increases depending on the variety of the asset classes and assets held by the investor. Since typically distinct asset classes and individual assets perform differently, the performance of a diversified portfolio of investments is more balanced than the performance of a less diversified portfolio or just one single asset.
Gold is an asset class in its own. Gold investments have also different characteristics than investments in other commodities or precious metals. That means the value of a gold asset often shows a low correlation with other investments and asset classes. Investing in gold can therefore be a suitable way to diversify a portfolio.
Investors seeking to avert risk should diversify their portfolios across several different asset classes and assets. Studies from Mercer and Oxford Economics come to the conclusion that investing 5% of a portfolio in gold investments is a good way to diversify. Depending on assumptions about future inflation or deflation and economic growth rates as well as individual risk preferences, higher allocations to gold investments could also be sensible. Typical recommendations range from 5 – 15%.
Hedging with gold
There are two ways to reduce risk: diversification and hedging. While diversification is based on low or uncorrelated assets, hedging is based on negatively correlated assets. If two assets are negatively correlated it means that when one asset increases in price the price of the other asset falls and vice versa.
Investing in negatively correlated assets or hedging allows for even more risk reduction than diversification. Since gold has a low or sometimes even negative correlation with other asset classes, gold can be an effective hedge, e.g. against a devaluation of money (inflation) or economic recessions often accompanied by falling stock and share prices.
See the following video from the World Gold Council on hedging against tail risks with gold:
In its analyses the World Gold Council found that even relatively small allocations to gold, ranging between 2.5% and 9.0%, help to reduce the risk of an investment portfolio.
Speculating in gold
Besides diversification and hedging, speculation is a third reason to invest in gold. But, as with every other asset class, it is very difficult to predict the future price of gold and the value of a gold investment.
Contrary to diversification and hedging, speculation on a rising gold price is generally done by allocating more funds in gold investments than recommended for diversification or hedging purposes and this technically increases the risk of a portfolio. But this is only true from a theoretical standpoint. In reality, if the gold price performs better than other asset prices, the investor’s return will increase with speculating on a rising gold price.
If investors want to invest in gold for speculative purposes, it is up to them to decide how much to invest in gold. There is no formula to estimate the optimal allocation. Generally speaking, the higher the gold investment, the higher the risk of loss but also the higher the potential return.
Forecasts on the future price of gold vary widely. David Rosenberg, chief economist at Gluskin Sheff & Associates, estimated in 2010 that a gold price of 3,000 US-Dollars per ounce would be possible within the next several years. Commodity investor Jim Rogers estimated that the price of gold could rise to 2,000 US-Dollars over the decade from 2010-2020. On the other hand, Morningstar, a leading provider of investment research, forecasted in April 2011 that the price would only reach 1,200 US-Dollars by 2014.
Expert recommendations on how much gold private investors should own
As described above, there is not one answer to the question of how much gold to buy. It depends on individual preferences regarding risk and return as well as on basic assumptions about the future performance of the price of gold.
Commodity analyst Klaus Weinberg of the German bank Commerzbank is cited as saying any investment between 5-15% in gold would be right. This is also a typical recommendation from private banks and wealth managers to clients asking how much to invest in gold.