How Gold Can Provide Stratospheric Returns to Your Investment Portfolio… if You Can Avoid the Bubbles!

A while ago, I took a look at the performance of gold over the past few decades, and I recently looked at the hot activity in precious metals. There was a great discussion on that post on the merits of investing in gold versus the stock market, and fellow bloggers shared their views on the fundamentals behind the recent price rise and where it’s going to go next.

I don’t generally believe in short-term market timing; I did recently sell off a portion of my precious metals, but I did it both on the basis that there was a little too much fear & greed going around last week and on the basis that my current plan is to stick to a 10% asset allocation in precious metals. Otherwise, I concede that short-term timing is probably not much different than playing craps at the casino. How about long-term timing based on fundamentals?

The analysis

Here are the assumptions:

• I will compare the performance of gold against the total returns of the Wilshire 5000 stock market index, which tracks the returns of all stocks actively traded in the U.S. markets.
• Starting in 1975, our fictional investor will invest $1 000 in gold every year, at the beginning of the year, at the London P.M fix price. This $1 000 will increase by 3% per year.
• The same amount of cash will also be invested in units of the Wilshire 5000 index.
• There is also a third scenario for our savvy investor. He will switch his portfolio between gold and the Wilshire 5000, at these times:
  • 1978: Switch from the market to gold.
  • 1981: Switch from gold to the market.
  • 2001: Switch from the market back to gold.
• I’ll also look at the case where our investor switches a couple of years later, after the bubbles have burst.

Here is the basic analysis for investing in gold versus the Wilshire 5000:

So as we can see, the stock market has performed better than gold when invested in regularly over the past 35 years. However, what if our investor was prescient enough to shift his portfolio between the stock market and gold whenever he sensed a bubble coming? Well, his returns can be seen in the following chart:

By switching between the stock market and gold at the moments before each bubble burst, our investor has drastically increased his total returns. What if he hadn’t had such good foresight in selling, and only got out two years later, after each bubble burst?

Our investor’s returns are demolished, but interestingly, he still ended up better off than he would have had he stuck 100% to gold! This kind of result might be typical if you let your fear & greed get the best of you and try to chase your losses after going through a collapse. While this market timing strategy can be rather risky, there is no need to commit your entire portfolio to this risk. Just investing 20% of income into a gold-or-stock strategy is sufficient to greatly increase returns, if you sell before the bubble bursts:

It is very easy to talk about bubbles in hindsight, but how can we detect one while it is in progress? The first gold bubble saw the gold price increasing by more than 100% in a year; the Wilshire 5000 had a few stellar years of 25%+ before declining. Here are a couple of ratios which show the relation between gold and the Wilshire 5000 over the past 35 years:

The results

Overall compound annual growth rates (CAGRs) of the various strategies:

	Overall CAGR, 1975-2010
Gold	6.6%
Bad market timing	9.4%
Wilshire 5000	10.1%
80% Wilshire 5000; 20% Gold market timing	13.1%
Gold market timing	17.6%

The trick is avoiding the burst 🙂 For the next post in this series, I’ll look at more investment strategies, both with and without timing. So, reader, what do you think? Maybe the 1980 bubble would have been easy to avoid after a 150% rise, but what were the signs of the subsequent malinvestments?