One ship drives east and another drives west
With the self-same winds that blow.
‘Tis the set of the sails
And not the gales
Which tells us the way to go.

Ella Wheeler Wilcox, The Winds of Fate

Future returns are unknowable with any degree of precision. A portfolio must contend with all that future market prices and developments put before it, whilst seeking to earn the best possible return for the level of risk assumed.

This uncertainty is a core issue for portfolio design. Part of my approach to building my FIRE portfolio has been to target a small allocation to alternatives such as gold and Bitcoin to deliver reduced portfolio volatility, and improved returns. My current target allocation set earlier this year is 7.5 per cent gold and 2.5 per cent Bitcoin. This post explores the reasons for, and basis of, this approach.

Portfolio design – one wind, different directions

In designing the FIRE portfolio, the key guiding principle has been maximising the overall risk-adjusted return, whilst minimising unnecessary volatility.

The important implication of this is that it is not the performance of the individual portfolio parts that I am trying to maximise. Rather, it is the performance of all of the component parts as they interact that is of prime concern.

The objective is for the mix of all of these different holdings to play their part together to enhance portfolio returns or reduce volatility. Decisions on asset allocation – or the mix of assets held – has been repeatedly been shown in academic studies to explain around 90 per cent of the volatility of portfolio returns.

This approach is consistent with the simple guidance to diversify. Underlying it, however, are some observations of modern portfolio theory and the Capital Asset Pricing Model, that can be summarised in the following insights:

• the investor should seek to mix assets with non-correlated returns (i.e. returns that move in different directions) to achieve an optimum balance of likely returns and portfolio volatility
• not all extra risk taken by an investor is automatically compensated by higher returns
• the investor should consider each additional investment security or asset from the perspective of how it will contribute to overall portfolio risk and return

At any given time this can mean that one ‘wind’ will send the individual portfolio components in different directions. In short, the approach is not one that will deliver a portfolio without any losses or low returns in the set of assets held at any given time.

Asset correlation – assessing the crosswinds

The critical ingredients for the approach to be effective are assets that do not move together – that is, uncorrelated assets. A traditional example used in portfolio design are equities and bonds, which have over time often tended to move in opposite directions (e.g. be inversely correlated) in many markets. This is the basis for traditional investment guidance to include greater bond holdings to dampen the volatility of equities.

Gold has tended to have a low correlation to other asset classes. An example of the effects of this on equity portfolios is described in this research paper (pdf) – from the World Gold Council – which found that adding gold holdings to an all equity portfolio both lowered the volatility of returns and increased total returns over the 1968-1996 period (see p.47 and Figure 4.6). The academic evidence for the low correlation of gold to equity returns is, in fact, strong over multiple periods.

Moreover, this diversification benefit appears when most needed. As this recent paper in the International Review of Financial Analysis notes:

…we think that a review of the results from earlier papers on this issue,
coupled with our findings, points to the fact that gold is always a hedge or, at
worst, always an excellent diversifier of portfolio risk. Gold’s usefulness in
managing risk does not disappear in a crisis when the prices of the vast
majority of assets tend to be perfectly correlated. (He, 2018)

That is, gold seems to generally hold up as providing non-correlated returns, even when extreme market conditions prevail. Globally, central banks – including Australia’s Reserve Bank – also seem to recognise this characteristic. It is in part why central banks collectively own around 17 per cent of gold currently above ground.

Setting the level of gold exposure – competing evidence

There is considerable discussion and debate on the right level of gold holdings to maximise the diversification benefit, and few definitive answers.

The optimum level  will vary under most estimation approaches, which inevitably are based on models that build on historical observed relationships and correlations. These correlations themselves vary over time and between markets and countries.

An original study by Jaffe for institutional portfolio managers recommended a 10 per cent allocation against a basket of international equities. Additional studies (pdf) by other authors have recommended 9.5 per cent, and between 0.1 per cent to 12 per cent depending on which country the investor is in. As an example, the country-specific weights typically fell within 3 to 8 per cent for developed countries.

More complex methods than classical mean variance analysis, which take into account the positive skew of gold returns, produce different results again. A 2006 study which examined 1988-2003 data recommended a holding of 4-6 per cent under classical portfolio optimisation approaches, but a lower figure of 2-4 per cent taking return ‘skewness’ into account.

Diversification and Bitcoin – looking at the record

My purchase of Bitcoin began as an exploration of a new financial technology driven by curiosity. The present question is, however, does it deliver any additional diversification benefits beyond gold holdings?

Conceptually, Bitcoin can be said to share some characteristics with gold that might be expected to reduce any diversification benefit. They both represent highly liquid assets that when held personally are no other parties liability. They are not issued by central banks or other monetary authorities, and they can be transferred. So is there a case for holding just one or the other?

The tentative answer is that despite some conceptual similarities, they do appear to behave differently.

So far, in the decade between July 2009 and February 2019, Bitcoin has shown a low positive correlation to gold (see In Gold We Trust (pdf), p.245). This is consistent with my own observations in my portfolio in the last three and a half year period, with a low correlation of 0.1 over the entire period in the chart below.

On its face it appears Bitcoin may well be a useful complementary alternative holding, offering diversification benefits distinct from other combinations of holdings.

Unlike gold, there is not a clear empirical or academic basis for setting a ‘right’ level of exposure to Bitcoin. The recent In Gold We Trust report (pdf) discusses and analyses one possible approach – a 70/30 split between gold and Bitcoin, indicating that this delivered similar maximum drawdowns to a gold only portfolio, but with higher returns. Yet this finding is only a function of the extraordinary positive returns from Bitcoin to date, and may not be repeated.

Trade-offs, risks and limits of exposure to alternatives

There are acknowledged trade-offs and risks to investing in alternatives such as gold and Bitcoin.

First, they produce no income or cashflow. Their return is based entirely on capital gains. This is often cited as a definitive proof that they do not represent part of any proper investment portfolio.

Yet, as a part of a portfolio, alternatives can reduce the absolute volatility of the capital value of the portfolio, and – historically in the case of gold, can also increase overall returns. Given final capital value and returns over time are critical inputs into FI, these characteristics are relevant and worth considering.

A potentially stronger objection is that while alternatives may have been useful in the past, they cannot be guaranteed to be so in the future.

That is, the correlations and diversification benefit that has been observed, may disappear. This is entirely possible, and ultimately unknowable. The diversification benefits of gold have a far longer history. Its roles in industry, manufacturing and jewellery would seem likely to continue to guarantee that at any given time there will be some minimum demand for gold, and a relationship between its price and other asset prices that is not perfectly correlated.

For Bitcoin, the same cannot be said. There are many plausible scenarios in which Bitcoin’s value declines, it falls in usage, and becomes the equivalent of niche digital collectible with little residual value.

The disappearance or long-term reversal of ‘known truths’ in finance is not impossible. There are significant periods in capital markets in which bonds outperformed equities, negative yielding debt has moved from something previously unobserved, to a commonplace across many world bond markets. By some measures, global interest rates are at 5 000 year lows. Few developments should be dismissed as inconceivable looking forward.

This suggests that any analysis based on historical trends should be relied on with modest expectations around its accuracy. Yet importantly, this applies not just to speculation around the role and benefits of alternatives. It also applies to traditional investment classes, such as equities or bonds.

For example, the continuation of a positive equity premium for Australia, or any other nation, is not foreordained. Australia’s comparatively high equity returns are in fact an anomaly looking across developed countries. There are no particularly strong reasons to suggest this will necessarily continue.

Set of the sails – applying the evidence to a FIRE portfolio

The role of gold and Bitcoin are primarily as non-correlated financial instruments for diversification, and as an insurance against extreme capital market events. No actual positive return is assumed for either asset. The evidence discussed above leads me to the following conclusions, for my personal circumstances and risk tolerance.

• Reliance on equities as the engine for portfolio growth. Long term equities continue to have a strong record of providing higher total returns, earning their place as the centrepiece of the portfolio.
• Reliance on history of performance of gold to reduce volatility. Some exposure to gold appears to reduce volatility and potentially enhance returns historically, making it a potentially beneficial addition to my FIRE portfolio.
• A small role for gold based on tested academic evidence. Past evidence suggests a gold allocation of between 5 to 10 per cent is sufficient to capture diversification benefits, without compromising long-term portfolio returns
• With Bitcoin potentially adding further diversification. Bitcoin appears to be non-correlated to equities, bonds, and gold, meaning it potentially is a useful further additional source of diversification benefit.
• But with modesty about what the future holds. Aside from Bitcoin being volatile, there is an inadequate history to know how it will perform compared to other assets through a full cycle, or whether it has a long-term future.
• Recognising the limits of knowledge and history. Asset performance, diversification benefits, volatility and returns which are historically based can and do reverse at times, meaning the ‘best’ portfolio will only ever be known in retrospect.

The alternatives target allocation set earlier this year is 7.5 per cent gold and 2.5 per cent Bitcoin. As of July 2019, a strict reading of these targets suggests I need to moderately lift my exposure to gold, and sell approximately 75 per cent of my Bitcoin holding.

I currently plan to do neither of these things. This is because:

1. The volatility of Bitcoin is such that ‘chasing’ a target allocation by buying and selling is likely to incur high transaction costs (including realising capital gain tax).
2. A plausible scenario is the apparent over-allocation to Bitcoin resolving itself through substantial price declines as previously experienced (at its previous low, the allocation was close to the 2.5 per cent target).
3. Similarly in the case of gold, both price volatility and the goal of minimising transaction costs suggest it is better to seek to adjust holdings only when they fall well outside the target allocation for a sustained period.
4. The overall size of the entire alternatives allocation (a 10 per cent target) is more significant than the individual sub-targets.
5. Before making new investments to pursue my portfolio allocation I perform a ‘with and without’ test, notionally removing the Bitcoin holdings for a moment from the portfolio, to identify if recent fluctuations in the value of Bitcoin are driving a perverse allocation choice which would be entirely different were it not for Bitcoin. While not theoretically ‘pure’, this is a pragmatic adaptive approach that recognises the lack of clear history and knowledge about the portfolio behaviour and characteristics of Bitcoin.

So the sails are set, and the wind will come. These settings allow me to feel that whatever direction they happen to blow, there is the best chance possible based on evidence that they will help in the journey that remains.

Sources

In Gold We Trust 2019 – Extended Report

Harmston, S. Gold as a Store of Value, Research Study No.22, World Gold Council, 1998

He, Zhen et al. “Is Gold Sometimes a Safe Haven or Always a Hedge for Equity Investors A Markov-Switching CAPM Approach for US and UK Stock Indices”, International Review of Financial Analysis, Vol. 60, October 2018

O’Connor, F et al. “The Financial Economics of Gold – A Survey” in International Review of Financial Analysis 41 · July 2015

Disclaimer: This article does not provide advice and is not a recommendation to invest in either gold, Bitcoin or any alternative assets. Its sole purpose is to provide an explanation of why – in my personal circumstances – I have chosen this exposure.