Gold Is Good for You

Gold. It is uniquely eye-catching, sports a deep, broad history that characterizes paper currencies as quaint short-term experiments, and at this point in the bull market, you may believe that you actually can taste it (something like an 18-year-old scotch, no?). But what of the hype is true?

Does holding gold really dampen portfolio volatility? Will it enhance your long-term returns? And while gold frequently rallies, does it consistently outperform when it matters most (i.e., when the world is falling apart)?

According to a recent study by the World Gold Council, or WGC, that examines gold's performance from January 1987 to June 2011, the answer in each case is yes -- although perhaps not to the extent that gold's most ardent supporters would like.

No matter, gold is good for you, and as you'll see by reading on, it doesn't take much imagination to recognize why.

A "foundation asset?"
Before I continue, let's establish that I'm not writing from a canned-food bunker; nor am I perched atop a safe stacked with bullion in place of a sensible desk chair. True, I've been terribly wrong on gold in the past, but my aim now, as always, is to think reasonably, not magically.

That said, let's dig into the first set of data points to see if it makes sense for the average investor to build his or her portfolio on a foundation of gold.

Below, I've compared the information ratio, or IR, of two diversified, globally oriented portfolios, each with and without a gold weighting. The information ratio, for those who are wondering, is a measure of risk-adjusted return, calculated by dividing return by volatility. As the formula suggests, a higher number indicates a more favorable performance.

Source: World Gold Council report "Gold: alternative investment, foundation asset," published Oct. 2011. Historical price data is from January 1987 to June 2011.

Hmm, while a gold weighting does indeed enhance risk-adjusted returns, the benefit is hardly overwhelming. Also, to cite another statistic from the WGC, at an annualized volatility of 14.6% in the January 1987-June 2011 period, gold does offer a smoother ride than large-cap, mid-cap, and small-cap U.S. equity indices, as well as commodities, but only by roughly one to six percentage points. Finally, in the more recent trailing three-year period, gold's standard deviation, as indicated by SPDR Gold Shares (NYSE: GLD), is actually slightly higher than that of the Dow Jones Industrial Average (INDEX: ^DJI).

So far, then, adding gold to one's portfolio mix looks like a decent but not brilliant idea. Ah, but we haven't yet reached the area where gold acquires its full luster -- the elusive but coveted land of low correlation and crisis-period outperformance.

On the first point, in the 1987-2011 period under consideration, gold shows a slight negative correlation to U.S. small-, mid-, and large-cap indices (-0.01 to -0.09), and a mere 0.12 and 0.13 correlation, respectively, to developed world and emerging market equities. Meanwhile, according to the WGC, alternatives such as hedge funds, real estate, and private equity are each more than 0.5 correlated to an average of the above indices while commodities are more than 0.25 correlated.

On the second point, shift your attention downward. The table below highlights the performance differential of two gold-weighted portfolios during periods of systemic financial stress, each benchmarked against identical portfolios that do not contain a gold component.

Source: World Gold Council report "Gold: alternative investment, foundation asset," published Oct. 2011. Historical price data is from January 1987 to June 2011. Portfolio compositions are identical to that of above table.

Clearly, gold minimized losses in all tail-risk periods except for the bursting of the dot-com bubble. I'll also call out 2008, when out of both popular, plain-vanilla and alternative assets, only gold and U.S. Treasuries turned in a gain. Now, as I've stated previously, this doesn't mean that gold has been, or will be, immune to an immediate sell-off as investors raise cash at the onset of crisis. However, following any initial shockwave, we see that gold has been a profitable place to hide out during troubled times. And so long as investors continue to pursue uncorrelated returns, I expect the pattern to hold.

Finally, simply buying and holding gold across the long-term, versus making tactical trades, hasn't detracted from returns. On the contrary, in the 1987-2011 period under scrutiny, a 3.7% allocation to gold in the standard portfolio described above would have boosted return by 0.6%.

Your rebuttal, please
I said that it doesn't take much imagination to see why owning gold makes sense. This arguably signals that the top is nigh, or worse, has already been met at just over $1900 an ounce back in August. Well, OK, but here we have a situation wherein what's obvious in mind is largely ignored in action: Put simply, gold is vastly under-owned. According to the WGC, at the end of 2010, gold bullion accounted for only about 1% of the worldwide $146 trillion assets under management, with "under allocation" more prominent among institutional investors.

Now, for the Average Joe or Jane who still can't shake the feeling that investing in gold is fundamentally different from (and riskier than) buying stocks and corporate bonds, where asset values are underpinned by company cash flows, hey, I get it. Once upon a time, I lived in that mind-set. But, underlying cash flows or not, consider that all investing is a wager on how human beings will respond to events. The "event" could be a company making what's perceived to be a pricey acquisition, as was recently the case for SAP; it could be disappointing flow rates, which have punctuated the roller-coaster tale of underdog ATP Oil & Gas (NYSE: ATPG); or, it might be the expectation that a high-impact worker strike, which has tarnished perceptions of mining heavyweight Freeport-McMoRan Copper & Gold (NYSE: FCX), will soon be resolved.

In other words, there is no financial law of nature. Assets move in price because and only because human beings price them. And in light of human behavior, where key motivators are hope and fear -- combined with the very real prospect of massive debt monetization to meet entitlements -- gold is no more or less speculative than any other asset.

See gold brilliantly
Could I be wrong? Sure. In theory, governments across the developed world could institute balanced budgets next year. Alternatively, things could really, really go to hell, in which case guns, bullets, and antibiotics would take the mantle of ultimate currency. Nonetheless, I urge investors to view gold as an insurance policy against things getting much worse but not Mad Max-level apocalyptic. To help you along your way to this point of view, consider the following: Who's ever described a 30-year-old who buys life or long-term care insurance as a reckless speculator?

Need another idea? If you want protection against a modest decline in gold prices and are comfortable believing that gold miners are eventually poised for a major upward revaluation, consider a handful of undervalued mining names. Here, I refer you to the much deeper knowledge base of my colleague Christopher Barker, who counts Primero Mining (NYSE: PPP), Yamana Gold (NYSE: AUY), and Goldcorp (NYSE: GG) as top picks in this area.

However you prefer to gain gold exposure, do so now. Similar to an insurance policy, you'll be relieved if you never need it, but unspeakably thankful if you do.

• Add SPDR Gold Shares to My Watchlist
• Add Primero Mining to My Watchlist
• Add Yamana Gold to My Watchlist
• Add Goldcorp to My Watchlist