Thinking of Adding Gold to a Classic 3-fund Portfolio

[aj76er]

Hi All,
I've been active on the bogleheads forum for quite some time now and found my way over here after reading about the HBPP.  I'm contemplating adding Gold to my classic 3-fund allocation, and would like to get the opinion of the forum.  My current investible portfolio is all in a 401k as follows:
40% VINIX - Vanguard Institutional shares S&P 500
10% DFFVX - DFA Small Cap Value
30% RERGX - American Funds International (includes Emerging)
20% VBTIX - Vanguard Institutional Shares Total U.S. Bond Market


I'm trying to assess how well the 3 fund portfolio performs during the 4 economic cycles, and my understanding is as follows:

On a scale of Poor-Fair-Good-Excellent:
1. Prosperity - Excellent (due to high allocation to stocks)
2. Recession - Fair-Good (due to bonds helping stabilize)
3. Deflation - Fair (12.5% LTT in TBM fund would seem to help here)
4. Inflation - Poor

So, I'm trying to improve the portfolio for case #4 - inflation.  I think most bogleheads try to add TIPS to the portfolio to help with this. I also think that most folks think that stocks hedge against inflation, but I've uncovered a lot of data that says otherwise.  When I backtest (synthetic) TIPS it does not do very well for the 70's/80's period when inflation spiked. 

So, to combat deflation/inflation better, I was thinking of a small allocation (~10%) to gold.  I've read conflicting reports about whether gold is a good hedge against inflation or instead deflation (or both).  But historical data does show that it is highly uncorrelated to stock price movement.  And it backtests quite well (I know this is no indication of future performance).

At any rate, do you agree with the above analysis? Do you think gold could help improve a 3-fund portfolio?  I was thinking of using GLD or IAU for this allocation (despite not liking ETF's, they appear to be the best, most convenient option). 

Thank you!

[Tyler]

Hi aj76er.  Welcome to the forum!

To help explain the benefit of gold, I'm going to reference two custom charts.  The first is for your portfolio (Total International isn't a perfect analog for RERGX but is close enough for discussion purposes):

[img width=500]http://i66.tinypic.com/mtxza.jpg[/img]

This shows the inflation-adjusted CAGR for every investing period since 1972.  Here you can very clearly see when the portfolio did well and when it struggled.  The 70's featured the double-whammy of rising inflation and rising interest rates, and the 2000's were full of general stock market turmoil.  Heavy stock investors often look solely at long-term averages that appear rosy because of the 80's and 90's but that obscure the tough years before and after. 

The next is your same portfolio with a slice of gold (I've bumped it up a little from your 10% goal for effect):

[img width=500]http://i65.tinypic.com/k18cac.jpg[/img]

Gold did very well in both the 70's and the 2000's, the two exact periods when the three-fund portfolio struggled.  As a result, adding gold smoothed out the overall ride considerably.  People like to debate how well it correlates to inflation, but I lean towards your observation that its negative correlation to stocks is just as valuable to an investor. 

The past is no guarantee of future returns, but you can still learn a lot about how different assets complement each other.  I personally think history teaches us that gold is a nice option for portfolio diversification.

[aj76er]

Thank you Tyler!

That sums it up very nicely .