What role does gold play in a portfolio?

Gold is one of the oldest stores of value, and many investors hold a small part of their portfolio in it — through physically backed exchange-traded commodities (ETCs), coins and bars, or funds. Unlike stocks and bonds, gold produces no income: no dividends and no interest. Its return comes entirely from changes in its price, and investors hold it mainly for what it does in combination with other assets.

Why investors hold it

Diversification: gold's price has had a low, sometimes negative, correlation with stocks, so it can move differently in a crisis.
A hedge against financial stress: gold has tended to rise when confidence in currencies, banks or governments falls.
A store of value over very long periods, though with long stretches in which it lost purchasing power.

Risk and return

Gold is volatile — historically around 15% a year, similar to stocks — but its swings have been largely independent of the stock market's. Its long-run real return has been low, and it has gone through very long periods of losses: after peaking in 1980, gold took almost three decades to regain its price in dollars, and longer still in real terms.

The effect on a portfolio

With a gold share $w_g$ , a volatility $\sigma_g$ for gold, $\sigma_s$ for the rest of the portfolio, and a correlation $\rho$ between them, the combined volatility is:

\sigma_p = \sqrt{(1 - w_g)^2 \sigma_s^2 + w_g^2 \sigma_g^2 + 2 \, w_g (1 - w_g) \, \rho \, \sigma_s \sigma_g}

A simple illustration

A stock portfolio has a volatility of 16%; gold has a volatility of 15% and no correlation with stocks. Moving 10% of the portfolio into gold gives:

\sigma_p = \sqrt{0.9^2 \times 0.16^2 + 0.1^2 \times 0.15^2} \approx 14.5\%

Volatility falls from 16% to about 14.5%, while the expected return falls by only a tenth of the difference between the returns of stocks and gold. In crises in which gold rose while stocks fell — as in 2008, when stocks lost around half their value from the peak and gold ended the year higher — the benefit was larger.

How much, and how

Typical allocations in diversified portfolios range from nothing to about 10%. Beyond that, a portfolio depends heavily on an asset that produces no income.
Physically backed ETCs are the most common way for private investors to hold gold; tax treatment differs by country and product, and is worth checking.
Gold mining stocks behave differently from gold itself: they are companies, with their own costs and risks, and are usually much more volatile.

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