The beauty and power of gold continues to fascinate us on many levels. Science tells us that when compared to gold, other colours and textures are simply not as attractive. The colour of gold evokes images of grandeur and extravagance and is associated with wealth. It naturally carries with it the message that you should own it.
In the world of business, where the colours used are mostly conservative, gold’s warming glow can be a more attractive prospect, if only at an emotional or psychological level. Given the emotions that gold evokes in us, it is hardly surprising that investing in gold becomes more attractive to anxious and worried investors during times of economic or political turbulence. After all, how soothing is it to think that one owns something solid with an undeniable value, beauty, and utility?
Gold, says Warren Buffett, “doesn’t do anything, except look at you”
The world’s most famous investor, Warren Buffet, says he prefers investments that pay dividends and make money, so perhaps the allure of this precious metal commodity must be tempered with a more realistic view of its value as an investment.
Buffett goes on to say; “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”1
Despite the sage words of the Oracle from Omaha, many investors are committed “gold-bugs”, insisting that holding gold investments is wise. They argue that it offers three benefits: first, as a haven in times of economic uncertainty, second as a hedge against inflation, and lastly as a general stabilising influence in a diverse investment portfolio.
Is Gold a Solid Investment?
The evidence to show that gold should be an essential part of a strong portfolio is not solid. Gold has not delivered significant growth relative to equities over the long term. 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.
The Facts Tarnish a Glittering Reputation
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.
So, let’s step back in time to the 1970s, a strong decade for gold. 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% per year and far surpassing the performance of other asset groups.
Viewed in isolation, this period suggests 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.
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.
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% annualised 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.2 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).3 By this measure, gold is over fifteen times more volatile than the CPI.
Gold as a Portfolio Diversifier
The claim that gold offers a portfolio diversification benefit due to its low historical correlation with stocks is shaky. (Correlation measures how closely two securities or asset groups perform relative to each other over a given time period.)4 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. History shows that, while gold has a long-term return like the S&P 500 Index, its volatility approaches that of US small value stocks which are 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.
All the components of an investment portfolio should have an expected return. As a material input, however, gold does not offer the potential for generating income or earnings. Any returns are due to 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.
And like collectibles, gold bullion safely stored away for decades can be counted on only to produce expensive bills for insurance, storage and other costs. Its value will merely reflect the current spot market price which, as we have explored, can fluctuate wildly.
In contrast, a stock reflects ownership in a real 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.
Gold’s glittering promise of certainty amidst the fluctuating fortunes of the world markets is perhaps just a beautiful dream that becomes quite alluring amid great uncertainty. When one looks carefully, though gold is pretty, it might not be doing pretty things in your portfolio.
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 us your comment or insight on the issue below.
Many thanks to Dimensional Fund Advisers for giving me permission to publish research from their original article “Is Gold Worth Its Weight”?
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.