How Much Gold Is Too Much?

How much gold is too much - if asked, most investors would probably say somewhere between 5% and 10%. Few would be comfortable with 25%, and a 40% allocation would strike many as risky, to say the least.

Yet before answering the question, we need to ask a more fundamental one: what is investment risk? Many in the industry equate risk with volatility. If an investment's price fluctuates wildly, it is deemed risky. If it is relatively stable, it is considered safe.

The problem is that history reveals the hidden dangers of such thinking. For much of the last forty years, government bonds were regarded as one of the safest investments available. Pension funds relied on them. Cautious investors owned them. Financial advisers recommended them. But then came 2022 when government bonds suffered some of their worst losses in generations. Investors who thought they owned a safe asset discovered that "safe" can be a remarkably slippery concept.

The key thing to recognise is that bonds did not change in 2022, but the economic environment had. This points to a truth that is often overlooked. Risk depends not only on the investment itself, but on the world in which it exists. An investor holding government bonds during the disinflationary era from the early 1980s onwards enjoyed one of the greatest bull markets in financial history. But an investor holding the same asset during the inflationary 1970s experienced something very different as rising inflation steadily eroded purchasing power. The same investment produced dramatically different outcomes because the environment was different. This highlights a form of risk that receives surprisingly little attention: environment risk. In simple terms, it is the risk that an investor positions their portfolio for one economic future only for a different one to emerge.

This is why I have never been entirely comfortable with volatility as a measure of risk. Although easy to calculate and convenient to use, it tells us little about the risks that matter most. Most investors do not lose sleep because an asset occasionally rises too much. They worry about losing a substantial portion of their savings or discovering that their wealth no longer supports the lifestyle they had planned. In short, they worry about outcomes. And the biggest risk investors face is not volatility but finding that the world evolves very differently from what their portfolio assumes.

This was the insight behind the investment philosophy of Harry Browne, who recognised that nobody knows whether the future will be dominated by strong growth, recession, inflation or deflation. Rather than trying to predict which environment would emerge, he proposed building a portfolio capable of surviving all four. His solution was elegantly simple, with 25% invested in equities, government bonds, gold and cash (rebalanced periodically).

To many, the gold allocation sounds extraordinary. But Browne wasn't really making a prediction about gold. He was making a statement about environment risk. He argued that if inflation is a genuine threat to wealth, then portfolios should contain meaningful protection against it. Gold was not there because he expected it to outperform. It was there because he recognised that inflation was one possible future and wanted the portfolio to survive it.

Whether one agrees with Browne's solution is almost beside the point. The important insight is that he viewed diversification differently from most investors. Today, diversification is often defined as owning lots of different assets. Browne's definition was more sophisticated. He diversified across economic outcomes.

A conventional portfolio containing 60% equities and 40% bonds is generally regarded as diversified. Yet such a portfolio is making some significant assumptions about the future. It assumes inflation remains broadly under control, and that financial markets continue to function normally. Those assumptions may prove correct, but they are assumptions nonetheless. The portfolio is diversified across asset classes while remaining concentrated in a particular view of the future.

A portfolio containing 25% gold may look unconventional, but it is arguably less dependent on some of those assumptions than a traditional balanced portfolio. This does not mean that everyone should own 25% gold. Far from it. Gold has obvious drawbacks. It generates no income. It can experience long periods of disappointing performance. At times it can become expensive relative to other assets. Indeed, this is where I part company with Browne.

While I believe he was right to think about risk in terms of economic environments, I am less convinced that each environment should always receive the same weighting.

The investment case for gold at $250 per ounce in 1999 was very different from the case for gold at $1,900 in 2011. Likewise, government bonds yielding 15% in the early 1980s presented a very different opportunity from bonds yielding less than 1% in 2020. In short, valuations matter, economic conditions matter, and the probabilities attaching to each matter. Investing is not about predicting the future with certainty. It is about recognising that multiple futures are possible and ensuring that a portfolio is not excessively exposed to any one of them.

So, how much gold is too much? The truth is that there is no simple answer to this question. And it certainly cannot be answered by looking at gold in isolation, or by extrapolating from the past. It depends on the rest of the portfolio, the economic environment, the valuation of alternative assets and the risks an investor is trying to hedge.

Perhaps the more important question is not how much gold is too much, but whether investors truly understand the economic assumptions embedded within the portfolios they already own.