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September 7, 2016

Gold as a hedge? An empirical deep-dive

Our investment process is evidence-based and shuns the typical story-telling so beloved by the investment industry. To demonstrate our approach we want to use the example of gold. We are not gold-bugs or gold-haters, the only thing that counts for us is whether there is empirical evidence that gold should be part of a portfolio. More specifically, we are trying to answer two questions here: (1) what is the historical return and volatility of gold versus other asset classes, i.e. is it worth it and (2) what are the returns during times of crisis. i.e. is gold a good hedge? Professor Robert Barro and PhD student Sanjay Misra from the University of Harvard have done a study on exactly these topics and we will present the summary below:

Long-term performance: is 175 years enough?

In this study from the Harvard researchers, they compared the real return of gold, US equities and US 10 year treasuries from 1836 to 2011. A long time series is necessary to avoid cherry picking the data. Over that time frame, gold appreciated much less than equities and bonds but it had price swings (measured as standard deviation) significantly higher than bonds and actually close to equities.

1836-2011goldequities10 year treasuries
annual real return1.1%7.4%2.8%
standard deviation13%16%8%

Maybe you think going back to 1836 distorts the picture. How relevant is the financial history really once you go back more than 100 years? Fair point, but even if you choose a more recent period, the overall picture doesn’t change materially. Gold is still the worst performing asset and over that time frame it even ehibits the highest volatility! Less return than bonds but more risk? Gold is clearly not an efficient asset class and based on empirical evidence, it cannot be argued that gold should be part of a long-term portfolio.

1975-2011goldequities10 year treasuries
annual real return4.0%7.5%4.5%
standard deviation21%14%9%

What about gold as a hedge?

Maybe gold isn’t such a great long-term investment, but what about gold as the ultimate safe asset for hedging against uncertain times? The researchers have crunched the numbers again and found that the price of gold is moving independently of whatever the economy is doing! In the study, the researchers looked how gold performed during a series of „macroeconomic disasters“ – defined as periods when the countries’ real GDP dropped by more than 10% over a 3-4 year time period. This included for example the Great Depression in the US and the economic break-down of Germany and Japan during WWII. The researchers found 56 disaster periods between 1880 and 2011 – however, the price of gold only rose 2.1% a year in those periods compared to the long-term average price appreciation of 1.1.%. Still not convinced? Investors should maybe take a closer look at the last two stock market crashes: during 2000, even gold produced losses of 7% and during 2008, gold only managed to eke out a small gain of 4%. Gold doesn’t produce any income and is also not a good hedge – so why own it?

Summary – gold is religion

There may be many reasons for owning gold – but an attractive historical real return or low volatility is not one of them.

We have no idea where gold will trade at in 12 months from now. It is possible that gold will be the best performing asset class in the long-term. But it is not very probable based on historical evidence.

Individual investors always want to know what large institutional investors are thinking. Well, there is no larger institutional investor in Europe than the Norwegian Pension fund, which manages around EUR 750bn and they do not own any gold. If professional investors are staying away from the shiny metal, shouldn’t that make us smaller investors think? Fear is a powerful factor in investing but we would be better served looking at the facts.

Sometimes a picture say more than a thousand words. The following chart shows the price of gold from 2010 to 2015. An asset that can rise 30% in one year (2010) and drop by nearly the same amount shortly thereafter (28% in 2013) hardly deserves to be treated as a safe and stable asset in our opinion.

Chart

Source:

http://www.nber.org/papers/w18759

http://blogs.wsj.com/moneybeat/2016/08/03/gold-may-not-be-the-hedge-investors-think-it-is/

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