5 Year Investment Plan using Equities and Gold

"If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks."
john bogle
- John Bogle
Founder of Vanguard Group

Can gold be an alternative diversification asset in your portfolio in this market? Here is a 5 Year Investment Plan example showing what would have happened if you invested in Equities and Gold over the past 30 years.  This is a simulation of consistent returns at pretty much any point during that time. Read how to Invest in Gold and diversify your Equity Portfolio. 

gold diversification benefits blackrock investment institute
Gold as an alternative diversification asset

Keep reading:

  • If you want to sleep well at night, don’t like high volatility and aiming for consistent returns of your portfolio with limited downside risk
  • But you are invested in Stocks because you fundamentally believe assets should generate cash 
  • If you wonder whether it’s possible to generate High Returns no matter at which point you enter the stock market
  • If you want to invest your savings over the Medium to Long Term (analysis done for a 5 year holding period but applies for longer horizon as well)
  • If (for any reason) you don’t want to invest in Bonds for diversification (although below you can see that the results were similar in the past to Gold)
  • If you want a portfolio that is Easy to Implement
  • If you want an investment that is Cost Effective
  • If you want to learn how to Invest in Gold through ETFs

1. Being 100% in Stocks - Why you can lose money

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” 

Now, look at the above chart and read the analysis below:

How does it work?

  • I assume that you want to fund a project in 5 years and I look at the last 30 years as guidance.
  • I also assume you don’t have time to gradually deploy and want to get returns in 5 years
  • I assume you may have invested at any point during the past 30 years (at the beginning of any quarter) and held the exposure for 5 years (any income is reinvested) This is important as it makes it less dependent on arbitrary starting point
  • Each blue bar is the annualized cumulative return over the 5 year period at the point of exit* (when you sell the exposure) of the S&P 500 Index (Dividend Reinvested)
  • Look at the chart above. As an example: if the investor sold his exposure in June 2003 (i.e. 5 year after intial investment) he would have generated an annual return of c. 6%.
  • By investing 100 in June 1998 would have got back 133 after accounting for the total return (100*1.06^5) in 2003
 

You can see a fundamental problem investing in stocks without hedge – almost the entire decade from 1997 until 2007 was ‘lost’ apart 2001 – 2003 period!

2. Two ways of Making Money and Staying Safe

Assuming you are/ aim to invest in stocks. There are two way of going about it in this market:

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2.1 High Returns through Dollar Cost Averaging  

A number of investors I know want high returns hence opt not to diversify from Stocks. They remain cash-rich. There are strategies you can deploy such as the COVID-19 bear market to lock S&P 500 returns no matter how the S&P will behave this year. The condition is having some cash on the side to invest should the stock market dive further (but this involved opportunity costs of holding cash!)

2.2 Hedging the Downside 

If you want to deploy most of your money to work without having significant cash on the side you’d typically hedge your Equity exposure by invest in some form of Fixed Income products e.g. Treasuries 

THE TRADITIONAL HEDGE - TREASURIES

How can you hedge the downside? Traditionally for a typical 5 Year Investment Plan you would diversify with a Fixed Income investment e.g. Treasuries. However, opportunity cost is a problem. Real rates (yields after accounting for inflation) are in fact negative. If you have e.g. 5 year investment objective and your bond portfolio is not matched (e.g. you hold longer duration treasuries to better hedge downside risk) you can also make losses.

Without going into the Maths the Ballpark Rule is that for a 20 year bond paying back the principal at maturity a 1% increase of interest rates brings your bond price down by 20%. You could make a case that nominal yields can go negative and you can make profits the same way but the risk is asymmetric to the downside (look at the below graph). Some even argue it’s flat-out foolish to hold bonds in this environment

invest in gold to avoid negative real yields -s US treasury yield curve rate T note constant maturity 10 year
10 Year Treasury Yields - the income that Treasuries generate has historically never been lower

3. Can Gold act as alternative to Bonds for a 5 Year Investment Plan?

50 percent S&p 500 50% gold and 50% bonds
Starting with an extreme scenario for very risk averse investors. Simulation of annual return for a 5 year holding period of mix portfolio of 50% Stocks and 50% Gold or Bonds

How does it work?

  • I assumed that an investor invested at any point during the past 30 years (at the beginning of any quarter) and held the exposure for 5 years (any income is reinvested)
  • Each blue bar (Stock exposure diversified with Gold) or point on the red curve (Stocks diversified with Treasuries) is the annualized cumulative return over the 5 year period at the point of exit* 
  • Again, please look at the chart above. As an example if the investor sold his exposure in July 2013 (i.e. 5 year after intial investment) he would have generated an annual return of c. 9%.
  • By investing 100 in July 2008 the investment would have returned over 150 in total(100*1.09^5).
  • It wouldn’t have mattered if the investor put 50% in Bonds or Gold since both red and blue charts cross at that point in time (same outcome)
  • You can easily visualize when Gold vs. Treasuries were more advantageous (but again, in real life you don’t have the advantage of this hindsight)
READ  Should I Invest in one go?| Lump Sum Investing vs. Dollar Cost Averaging

Two interesting allocations - 40% and 20% Gold, the rest is S&P 500

How to Invest in Gold ETF 60 percent S&p 500 40% gold and 40% bonds
Simulation of annual return for a 5 year holding period of mix portfolio of 60% Stocks and 40% Gold or Bonds
how to invest in gold ETFs 80 percent S&p 500 20% gold and 20% bonds
Simulation of annual return for a 5 year holding period of mix portfolio of 80% Stocks and 20% Gold or Bonds

Gold can replace Treasuries for Long Term Investors

Treasuries enjoyed a substantial rally in the last decades (CME did an interesting analysis with longer time horizon on Bonds and Gold) with falling yields. Gold is capable of delivering an interesting diversification role especially in an environment where Real Rates (or the opportunity cost of holding Gold vs. Bonds) are negative. There is currently little upside in Treasury Bonds when taking them on a standalone basis. The general recommendation that you hear in media is to have some marginal exposure to Gold as part of a wider portfolio (5%-7%)

As a reminder, this analysis is a simplified one and only assumes one diversifier for comparison 

 

Ideally you want to have a mix of e.g. Fixed Income Aggregate Funds and Gold. 

However, analyzing the data over the past 30 years the diversification away from stocks should be at least 20%. Interestingly, the hedge was superior to bonds if you invested in 2004 and needed to exit in during the GFC in 2009.

  • A 80% Stock and 20% Bonds or Gold allocation would have significantly reduced your downside risk and generated consistent returns
  • 60% Stocks 40% Bonds or Gold allocation is somewhat extreme as you forego some upside but pretty robust if you think the markets are unstable. Outside of an isolated case it’s been a profitable mix over the past 30 years

4. Few takeaways from this analysis

The ideal mix depends on your risk tolerance and return requirements. While we’ve been more obsessed by downside risk in this article returns are arguably as important. The below table is also quite interesting.

There were 120 distinct scenarios (30 years x 4 quarters) with different entry points making it independent on the starting point (again, using a 5 year holding period)


Using a 60% S&P 500 40% Gold allocation investing at any time would have generated you at least 6% annually over 5 years in 75% of cases. As comparison, 80% S&P 500 and 20% Gold would have generated at least 5.2% in 75% cases but with better upside in 25% of cases (16.5% vs. 13.1%)

how to invest in gold etf gold equities bonds treasuries comparison
Illustrative Return percentiles for S&P 500 and Gold/Bond Portfolio mix. Quarterly data with S&P 500 returns represented by S&P500 Total Return Index. Treasury Portfolio modelled with Bloomberg Barclays US Long Treasury Total Return Index

*No rebalancing is modelled in this analysis

5. A word of caution

Note that Gold acts as Long Term Diversifier

It can (and has during the 2008 Global Financial Crisis) moved in line with Equities over the short term due to technical reasons. This happens with a sudden shock when investors initially liquidate their ‘winners’ to cover margins on loss making positions. Gold has subsequently rallied with central bank stimulus announcements. The same happened mid-March 2020 with a fall in prices followed by a rally.

You should also understand factors impacting Gold Prices and if now is a good time time to buy Gold

READ  Do I need Bonds in my Portfolio? Understand how Bonds improve the odds of higher returns

HOW TO INVEST

Research the appropriate ETF based on your needs

  • Large US Equity ETFs by size are listed here. Some are covering the S&P 500 Index covered in this article.
  • Understand factors affecting Prices – is now a good time to buy Gold?
  • How to invest in Gold? While you may consider physical gold your starting point to look for Gold  ETF candidates is also on the ETFdb website.
  • In case you’re curious about Fixed Income ETFs you can have an overview of the largest Government Bond ETFs here. However, be aware of the asymmetric nature of the current market – be aware the Treasury Bond Funds can also go down
  • Another alternative to Treasuries in a 5 year Investment Plan are e.g. Aggregate (Core) Bond Funds which is a mix of Treasuries, High Quality Mortgage Backed Securities and Corporates. They have the advantage of generating income (vs. Gold). You can review a Best Bond ETFs in each category here

Investigate Liquidity, Fees, Commissions and Taxes

  • Check the size of the fund and liquidity – it is usually preferable to stick to the larger vehicles that are more liquid
  • Low fees are the most cost-effective feature of an ETF – make sure you select a low fee vehicle. Check the expense ratios on the ETFdb website and plug them here. You can compare the effect of fees on your overall returns using our ETF fee calculator. You may be surprised of the high impact.
  • Before implementing the above guidelines on how to invest in Gold reflect on how is the purchase or sale of an ETF going to affect your tax return? While U.S. based ETFs have many tax advantages, a foreign ETF may not be so tax-friendly and therefore not cost-effective. Tax implications vary from region to region
  • Verify any commissions and fees charged by your broker

DISCLAIMER – the views expressed here are my own personal views. The above is a simplistic generic scenario analysis. The information provided is general in nature only and does not constitute personal financial advice. You should consider the appropriateness of the information having regard to your objectives. You should consider your financial situation and needs. Seek professional advice where appropriate. This website is not affiliated with any of the investment firms for which products are described here.  These are meant to be illustrative investments. Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to in this article, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. 

 

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freakin sweaat
freakin sweaat
2 months ago

thanks my only issue with GOLD or other commodities like it is that there’s nothing inherent about their value. GOLD is kinda like paper money. It has value because it has value, as believed by others. On the other hand, if I have a house/appt that I rent out, or a stock that pays a dividend…at the very least, I am holding assets which are creating value (and generating cash flow). I, personally, don’t understand the love affair with gold. It’s a shiny metal…that’s it. So, I keep it out of my investment portfolio altogether. Disclaimer (and interesting cultural story… Read more »

Jesse32
Jesse32
2 months ago

When would Gold stop performing?