Volatility and Returns

Previously we discussed whether bonds, gold, and commodities have a role to play in a balanced portfolio based on their correlation with equities and volatility.

Now let’s decide whether the balance of returns and volatility for bonds, gold, and commodities warrants adding these asset classes to a stock portfolio.

As we now know, the correlation between stocks and other asset classes is extremely variable. However, when measuring the volatility of asset classes, one finds that volatility is more stable over time and therefore easier to measure when developing an asset allocation strategy.

The key is to understand the relationship between the expected returns and the volatility of an asset class.

First, one must understand that volatility can flatten returns like a pancake.

Asset class efficiency is measured by the Sharpe Ratio, which is calculated by subtracting the expected return on Treasury Bills from the asset class’ expected return and dividing the result by the corresponding historical volatility of the asset class.

For investors with a long-term time horizon, Gold and commodities both have lower efficiency and positive correlations to stocks.

From a long-term asset-allocation standpoint, 30% of your asset allocation strategy should include bonds to improve the efficiency of the overall portfolio.

Adding gold or commodities to a stock portfolio will drag on returns, increase volatility, decrease efficiency, and, most importantly, decrease the cumulative qains of the overall portfolio.