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June 2, 2014

Gold – there is only one good reason to own it

After years of rising gold prices, 2013 delivered serious losses to investors in the shiny metal. Should investors take advantage of the lower price of gold to buy? In this article we explain why there is only one rational reason to buy gold while the popular reasons don’t hold up under scrutiny

Gold has only one role to play in a portfolio: diversification

Gold can serve one useful purpose when structuring a portfolio: diversification. Gold can be a reasonably good hedge against various tail-risk events. Hedges are like insurance: they are there to help you in the unlikely event that a low-probability unexpected event suddenly knocks your portfolio off course. But gold should only be 5% to max 10% of a portfolio in our opinion.

Popular myth #1: Gold is safer than equities

Most private investors probably bought gold in the last few years because of what can best be described as a „fear trade“. Share prices collapsed twice in the last 14 years more than 40% (2000 and 2008). Although the prices have always recovered, the big drawdowns have undermined investor confidence in the equity market. To witness the Eurocrisis nearly spin out of control so quickly after the financial crisis lead to even more mistrust towards financial markets and governments. Private investors understandably were looking for something ‚safer‘ and started piling into gold. However, we think buying gold because you are scared of equities or bonds is flawed for a couple of reasons:

  • The biggest drawback to gold is its volatility, which since 1968 has exceeded that of the S&P500, at 20% versus 16%. Also during times of market stress, gold has not been able to protect investors. From March 2008 to November 2008, the price of gold dropped by 30%. Between Sept. 2011 and June 2013, the price of gold dropped by nearly 40%.
  • Never mind the volatility but what is really disappointing is the long term performance of gold versus equities. For the period 1928-2013, the average annual compound real return of stocks was 6.3% while gold was only 2.0%. Gold bugs will hastily add that the price of gold was controlled by the government until the mid-70s when the US finally abandoned the gold standard. But the picture for the period 1976-2013 is pretty much the same: the average returns were stocks 7.2% and gold 2.0%.
  • Nearly all of the long-term returns for equities are positive. Returns are positive about 80 percent of the time for 10-year rolling returns and considerably higher than that for 15-year rolling returns. For US equities, every period of rolling returns greater than 15 years is positive. Gold, on the other hand, can’t make the same claim. There are positive and negative return rates, regardless of the length of time an investor was willing to hold onto their gold. Even some 40-year periods still yield negative rates of return. Are you willing to wait more than 40 years to see positive returns.
  • Governments can easily take gold away from their citizens. You think this sounds far-fetched? That‘s exactly what happened in the US in 1933, when under Franklin D. Roosevelt gold ownership became a felony, punishable by up to 10 years in prison and fines up to $10,000. Americans were given only 25 days to surrender their gold.
  • The price of gold is pure speculation. Gold does not produce any returns like property, bonds or equities and it is therefore impossible to derive a fair value of the asset. Gold plays no role in the real economy other than for jewelry.
  • To buy gold today with the expectation that next year there would be more people with more fear (thus creating more demand and higher prices) has nothing to do with investing but constitutes betting. Warren Buffett, who is universally seen as the most successful investor of the last century has several times stated in public his dislike for gold. Buffett once said „it’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that“.

Popular myth #2: Gold is an inflation hedge

There are two popular misconceptions about gold. First, that gold is an inflation hedge in terms of how gold moves with inflation. Over the last 100+years, the correlation of annual returns of gold and of inflation is only 23%. Second, the long-run performance of gold handily beats inflation. I guess it depends how you define ‚long-run‘ but gold did not deliver positive real returns for 100y from 1870 to 1970 or from 1980 to 2005. Yes, there were short periods of outperformance, but that means cherry-picking your data. There is no consistent long-term trend of gold beating inflation.

What drives the price of gold?

Gold is just another currency. As such, the price of gold depends on the level of interest rates on government bonds which are its main alternative. In essence, higher interest rates on bonds makes holding gold relatively unattractive while low interest rates reduces the opportunity costs. It is therefore unsurprising that the correlation in the last 10 years between the interest rate on 10y US treasuries and the price of gold was close to 80%. If past is prologue, then an increast of the interest rate of 10y US treasuries to 4% would lead to a drop in the price of gold to around $800.

Gold - US treasuries correlation

Diversification is important but what we really want is low correlation

Diversification is a worthwhile goal but investors shouldn’t forget that the real goal is to find uncorrelated assets. Just because you invest in different asset classes such as gold doesn’t mean that this automatically reduces the volatility of your portfolio. In fact, during times of market stress the price of gold often exhibited price declines.

 US equitiesGoldUS 10y treasuries
1987 Crash-28%+7%+7%
Q1-Q3 1990 (US recession, Iraq war)-15%-6%0%
Juli-Aug 1998 (Asia crisis)-17%-7%4%
2000-2002 (US recession, Nasdaq bubble bursts)-44%+17%29%
March 2008-March 2009 (financial crisis)-54%-4%16%

There may be better alternatives than gold if the motivation is to find a hedge for economic uncertainty or political unrest. During periods of market stress for equities, the asset that has performed most consistently across time is U.S. Treasuries. The role of high-quality bonds as a diversifier, especially during sharp equity market declines, remains intact regardless of yields and justifies their inclusion in balanced portfolios.

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