Somewhere between beauty and value lies our obsession with gold. The appeal of its colour and lustre has endured millennia. No other element has challenged its supremacy or matched its timeless allure. It loses nothing by contact with fire and resists corrosion by the air, by water and indeed by almost all chemical agents. Gold is associated with immortality, and thus with royalty and divinity. It was the first material gift to Jesus brought by the wise men. The Buddha is gilded as an indication of enlightenment and perfection. Gold has inspired our highest ideals: the “golden section”, the “golden mean” and the “golden rule”.
Great human achievements are frequently rewarded with gold medals and trophies. Gold is further associated with the wisdom of aging and fruition. The fiftieth wedding anniversary is golden. Our most valued or most successful latter years are sometimes considered “golden years”. The height of a civilization is referred to as a “golden age”.
The first coins were stamped out of electrum, a natural alloy of gold in Lydia in the 17th century BC. Around 550BC King Croesus minted pure gold coins backed by state authority, transforming trade and banking and sealing the status of gold as our greatest expression of wealth.
Many investors tout the benefits of holding gold, considering its often-cited portfolio benefits: a strong long-term return, a hedge against inflation, and safe haven during turbulent times.
In modern times, it has played a key role in finance. The price of gold is determined through trading in the gold and derivatives markets, but a procedure known as the Gold Fixing in London, originating in September 1919, provides a daily benchmark price to the industry. Many investors tout the benefits of holding gold, considering its often-cited portfolio benefits: a strong long-term return, a hedge against inflation, and safe haven during turbulent times.
Is gold really worth its weight in a portfolio?
The evidence raises doubt about gold as an essential component in a portfolio. Over time, gold has not delivered significant growth relative to equities. While in real terms gold has preserved its value, it may not closely track inflation over shorter time periods. Moreover, gold’s early and recent performance should not obscure the two decades in which it depreciated considerably. Finally, gold is more volatile than other asset groups and does not generate positive cash flows, reducing its potential benefit as a portfolio stabiliser.
Famed investor Warren Buffett aptly summarised gold’s speculative nature in a Fortune article “Why Stocks Beat Gold and Bonds”:
“Today, the world’s gold stock is about 170,000 metric tons. If it were all melded together, it would form a cube of about 68 feet per side (fitting within a baseball infield). At $1,750 per ounce, it would be worth $9.6 trillion.
“With the same amount of money, you could buy all US cropland (400 million acres with output of $200 billion annually) plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually), and still have about $1 trillion in cash.”
Gold’s Long-Term Performance
Investors who think of gold as having strong long-term returns base their belief on two strong performance periods in the past four decades—the most recent decade and the 1970s. These periods account for most of gold’s price appreciation.
When Gordon Brown, as Chancellor of the Exchequer, announced in the spring of 1999 that a substantial portion of the UK’s gold reserve would be sold, the price stood at about $280 per ounce. From 2000 through 2011, gold outperformed major equity asset classes around the world. In terms of real (inflation adjusted) growth, gold turned a dollar investment into $4.05, and US small cap stocks (as represented by the CRSP 6-10 Index) turned a dollar into $1.58, while the S&P 500 Index and MSCI World ex US Index lost value. Gold had a 12.3% annualized real return, versus -1.88% for the S&P 500 Index, -1.4% for the MSCI World ex US Index, and 3.9% for the CRSP 6-10 Index. In 2011, gold rose to a peak of over $1,900 per ounce. In sterling terms, the rally since 2008 was even more spectacular thanks to the weaker pound. However, gold began a sharp decent in 2013 a significant factor being the withdrawal of assets from exchange traded products backed by physical gold. This has eased up over the past couple of years and despite headwinds such as the end of quantitative easing and a possible interest rate hike in the US, it is currently valued at $1,147 per ounce not far of the low of 2013.
Now let’s step back in time to the other strong decade for gold—the 1970s. A dollar of gold in 1971 appreciated to $8.91 in real terms by January 1980, when it peaked at $850 per ounce, returning over 27% a year and far surpassing the performance of other asset groups.
Over time, gold has not delivered significant growth relative to equities. While in real terms gold has preserved its value, it may not closely track inflation over shorter time periods.
Some investors who are old enough to remember the 1970s associate the higher demand for gold with turbulent times. The decade was marked by political unrest, war, the 1973-74 bear market, two worldwide oil shocks (1973 and 1979), stagflation, Middle East conflict, and Cold War tensions. In some ways, the 1970s resembled the first decade of this century.
Viewed in isolation, the periods suggest that gold offers a reliable source of returns during economic and market distress. But the details show that rising demand for gold in the US was due not only to economic uncertainty, but also to changing monetary policy and federal legislation regarding individual ownership of bullion.
Fortunately, times eventually improved—and from a broader historical perspective, gold has not delivered the long-term performance that some investors imagine, especially during more stable economic periods. Gold has provided lower inflation-adjusted growth than other assets ($7.33 per dollar invested) and a lower average return—4.9% per year versus 5.3% for the S&P 500, 5.0% for non-US stocks, and 7.3% for US small cap stocks.
If one disregards the 1971-1974 period when US investors could not own it directly, gold’s long-term performance drops substantially. From 1975 through 2011, gold produced a real annualised return of only 1.82% and grew an invested dollar to only $1.95 (versus the $7.33 shown above). US small cap stocks returned 10.6% ($41.73), the S&P 500 returned 7.1% ($13.07), and non-US stocks returned 5.5% ($7.49).
Now let’s consider the twenty years between gold’s two high-performance periods in the 1970s and 2000s. Those decades are generally known for global economic expansion and positive stock market returns. Yet, gold delivered a -6.5% annualized return, compared with 10.7% for US small cap stocks, 13.3% for the S&P 500, and 9.2% for non-US stocks (MSCI World ex US Index). A dollar invested in gold dropped to 26 cents in real terms, while the other assets grew substantially.
So, from a long-term perspective, gold has not experienced a reliable or sustained rise in value. In fact, its price appreciation has been limited to unpredictable, isolated episodes of high demand. Investors who attempted to time these episodes, exposed their wealth to potentially higher risk and to the opportunity cost of missing out on stock market growth.
Gold as an Inflation Hedge
Some investors perceive gold as a good hedge against inflation and point to its recent record prices as evidence. Gold’s price has climbed substantially in nominal terms. But when adjusted for inflation, a dollar of gold in 1980 was worth $1.04 at the end of 2011.
Of course, gold’s performance relative to inflation has varied according to the time frame measured. In some periods, gold has outperformed inflation, while in other periods gold has failed to match it. For example, from 1970 through 2005, consumer prices more than doubled while gold lost 20% of its value.1 Gold’s unreliable performance relative to inflation also comes with much higher volatility. Since 1970, its standard deviation has been over 19%, compared with 1.2% for the Consumer Price Index (CPI).2 By this measure, gold is over fifteen times more volatile than the CPI.
Gold as a Portfolio Diversifier
Proponents also claim that gold offers a portfolio diversification benefit due to its low historical correlation with stocks. (Correlation measures how closely two securities or asset groups perform relative to each other over a given time period. 3) This may be true when gold is held as an incremental part of a broader diversified commodity strategy within a portfolio. But correlation is not the only factor to consider in diversification. Volatility also matters, and history shows that, while gold has a long-term return similar to the S&P 500 Index, its volatility approaches that of US small value stocks, an asset class that historically has demonstrated a higher average return for the higher risk. So, holding gold as an asset class can make a portfolio considerably more volatile, which may offset the potential benefit of low correlation.
Also, according to modern financial principles, the components of a portfolio should have an expected return. As a material input, however, gold does not offer the potential for generating income or earnings. Its only source of return is price appreciation caused by shifting supply and demand. As gold’s historical performance shows, price appreciation is not a certainty. These characteristics make gold a speculative asset, like currency or collectibles.
Its association with the greatest expressions of wealth, wisdom and success may endure for generations to come. However, if you put gold in a vault and wait a few decades, it will not produce anything, and its value will reflect the current spot market price. In fact, holding physical bullion may incur negative cash flows due to storage, insurance, and other costs.
In contrast, a stock reflects ownership in a business enterprise that seeks to generate profits and produce more wealth. Investors who put their capital to work in the economy should expect a potential return from cash flows and appreciation. Over time this is the greater elixir – the real philosopher’s stone.
Do you think gold should be included in a broad based portfolio? Has your opinion about the long term value of gold been challenged? Please leave a comment.
Many thanks to Dimensional Fund Advisers for giving me permission to publish research from their original article “Is Gold Worth Its Weight?”.
1. Francesco Guerrera, “A Golden Age for Gold Loses Some of Its Luster,” Wall Street Journal, October 4, 2011.
2. Standard deviation is the statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution.
3. Correlation is computed into what is known as the correlation coefficient, which ranges between -1.0 and +1.0. Assets that have negative correlation tend to move in opposite directions, while assets with positive correlation have more similar performance. A zero correlation indicates no relation in performance. From 1971 to 2011, gold had a slightly negative long-term correlation with the US large cap stocks (”’0.001) and one-month US T-bills (”’0.07), and low correlation with US small cap stocks (+0.022). Correlation with non-US stocks was moderately positive (+0.21).
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.