Gold helps mitigate the risk of a stock-heavy portfolio, Axel Merk says.

With stocks and bonds rising ever upward on a path that cannot endure, currency funds manager Axel Merk suggests that now may be an appropriate time for investors to think about adding gold to their portfolios.

In a new white paper called “The Case for Gold,” the chief investment officer of Merk Investments says that success in investing depends optimizing risk-adjusted return over the long term, and by that measure the forlorn metal deserves more respect than it’s currently getting.

Merk’s white paper looks at three investing periods. In the last 10 years, gold had an exceptional run (until its dismal 28% loss last year).

But since this period also included the peak of the financial crisis, Merk also considered a period stretching back to August 1971, the point at which President Richard Nixon ended the dollar’s convertibility to gold.

And to counter any arguments that gold’s price was artificially depressed prior to that point, he also looked at a time horizon stretching to the beginning of 1934, when the Gold Reserve Act boosted the nominal price of gold from $20.67 to $35.

For all these periods, Merk compared the performance of gold-only and stocks-only portfolios with combined gold and stock portfolios optimized to have the highest Sharpe ratio (meaning that the portfolio would yield the highest risk-adjusted return).

Over the past 10 years, the highest Sharpe ratio over the “efficient frontier” (to cite the modern portfolio framework he employs) accrued to the investor who put 68% of his portfolio in gold and  just 32% in stocks.

Such an investor would have enjoyed an annualized return of 11.28%, but at far lower risk (15.51% standard deviation) compared to an all-gold portfolio (returning a higher 12.84% but with 20.05% volatility) or a S&P 500 all-stocks portfolio (returning 7.16% with 20.38% volatility).

“Does this mean an investor should have more than half of their investable assets in gold?” Merk asks. And he answers no, because historical returns do not guarantee future results and because the  investment universe offers more choices than just stocks and gold.

But this first portfolio test offers the first demonstration that one can improve risk-adjusted return by adding an uncorrelated asset to a portfolio of U.S. stocks.

The 30-plus year time period from 1971 to the present shows the same volatility reduction effect of a mixed portfolio.

In this period all-stocks (10.29%) outperformed all-gold (8.53%), but the combined portfolio with the highest Sharpe ratio — this time 29% gold and 71% U.S. stocks — sacrificed only a little (the return was 9.89%) while sharply reducing volatility (12.43% compared with 20.23% or 15.4% for all gold or all stocks).

Over the 80-year period, the optimal portfolio would have allocated 41% to gold and 59% to stocks and would have rewarded investors with 9.83% annual returns at a low volatility of 11.39% compared to an all-gold portfolio return just 5.02% with 15.38% volatility or an all S&P 500 portfolio returning 10.55% at 15.82% volatility.

For good measure, Merk additionally considered what effect adding gold had to a classic 60-40 stock-bond portfolio over the past 10 years and found that, once again, the highest Sharpe ratio was obtained at a high allocation to gold: 42%, with the remaining 58% in the balanced portfolio.

Once again, volatility was reduced (11.35% vs. 20.05% for gold only and 11.92% for stocks and bonds only) while the 9.87% return was closer to the all-gold 12.84% than the balanced portfolio’s 6.72% result.

Merk’s takeaway is that investors would do well to add noncorrelating assets to a portfolio and notes that gold’s correlation to U.S. stocks (0.07) is far below that of alternative investments such as international equities (0.50); hedge funds (.058); and real estate (0.80). Gold even correlates less than currencies and commodities generally, though managed futures has the least correlation with U.S. stocks.

What’s more, Merk proposes that investors in international equities are obtaining their return at higher risk more than through an improvement of their portfolios’ risk-return profile.

Given the age of today’s bull market in both stocks and bonds alike, Merk concludes that investors should think hard about protecting their portfolios against the next losing streak that lasts longer than just a few days.

He concludes:

“Most investors don’t allocate 30%+ of their portfolios to gold; neither can we make such an investment recommendation. But … we should really be asking the opposite question: Is it sensible for investors to have up to 70%, possibly more, of their portfolio in stocks?”