Does gold belong in a risk premia portfolio?

With GLD up 40-something percent since early 2024, I’ve been thinking about gold’s place in a risk premia harvesting portfolio.

It’s a fascinating rabbit hole and there’s plenty of disagreement.

Let’s break this down from two perspectives – the academic one (yawn) and the practical one (which is what actually matters if you want to make money).

Academically speaking, gold shouldn’t have a risk premium:

• It produces zero cash flows
• There’s no mechanism to determine “fair value” like we have with stocks or bonds
• Returns come purely from price appreciation, driven largely by sentiment and speculation

But it gets interesting when we look at what actually happens in the market:

• Gold has historically acted as a store of value (people run to it when inflation fears spike)
• It shows low correlation with equities, especially during market tantrums
• It’s widely perceived as a “risk off” asset

So while the theory says “no premium,” the practice shows “useful diversifier.”

I learned some interesting things about gold from talking to other traders recently:

• There’s surprisingly little of it. All the gold ever mined would fit in a cube inside a baseball diamond.
• It’s been coveted for at least 6,000 years, primarily because it’s shiny and doesn’t corrode.
• It has value largely because people agree it has value (industrial usage is relatively minor).
• This makes gold somewhat like Bitcoin – it has value because it has value (notably, just like fiat currency too).

What makes gold interesting is how it behaves in a portfolio. More than bonds, it switches between being a hedge asset and a risk asset. The reasons for each regime are obvious in hindsight but rarely in advance. Bitcoin shows similar behavior.

Risk Premia Harvesting Portfolios

Let’s consider building a simple risk premia harvesting strategy. Assume our goals are minimal trading and maximum simplicity.

Here are three basic options:

Option 1: 100% equities

• Dead simple to implement
• Requires almost no management
• Highest expected total returns
• But also the highest variance and lowest risk-adjusted returns

Option 2: Split between equities and bonds

• Still fairly simple
• Requires occasional rebalancing
• Lower total returns
• Higher risk-adjusted returns

Option 3: Equities, bonds, and a diversifier like gold

• More complex (but not rocket science)
• More frequent rebalancing
• Lower total returns
• Potentially highest risk-adjusted returns
• Better performance during broad market downturns

So which approach is optimal?

All of them. And none of them.

More accurately, it depends entirely on your situation, objectives, and constraints.

If you’re 30+ years from retirement with a home and other assets and you have the stomach for it (not everyone does), an allocation to 100% equities in your retirement account might make sense. You’ve got time for the variance to wash out, and you’re not entirely dependent on that portfolio.

If you’re closing in on retirement, that equities/bonds portfolio might make more sense.

But if you’re running a trading business and want to harvest risk premia while protecting yourself during unpredictable downturns (without the hassle of rolling options positions), a VTI-TLT-GLD combination starts looking pretty attractive.

The key is understanding your own objectives and constraints – including risk tolerance, which many traders overlook.

There’s an art to recognizing uncertainty and constructing good bets despite it. No right or wrong answers, just different trade-offs.

Bottom line: Gold differs enough from stocks and bonds that including some in your portfolio might make sense, but ultimately it depends on you, your objectives, and your constraints.