- Gold is often viewed as a safe haven
that will protect you from inflation, market crashes,
anarchy and even the total failure of fiat currencies.
Gold is often cited
as having a negative correlation with stocks
and a positive correlation with inflation,
making it sound like an excellent diversifying asset
to hold in portfolios.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you why gold's glitter
does not earn a place in your portfolio.
Any investment can be placed in one of four main categories.
Cash flow producing assets, commodities,
currencies and collectibles.
Gold has some limited utility in industrial production,
meaning that it could be viewed as a commodity
and it may form a component of many collectibles,
but those are not what drive the demand for gold.
Gold is primarily used as a store of value.
People buy gold,
hoping that they can sell it for more later.
What gold is most certainly not
is a cashflow producing asset.
In a 2012 article,
Warren Buffett created an excellent analogy
to explain why this is important.
He explained that the world's gold stock at that time
was worth about 9.6 trillion U.S. dollars.
For that amount of money, explains Buffett,
"You could buy all of the crop land in the U.S.,
400 million acres with roughly $200 billion of annual output
and 16 ExxonMobils, each earning $40 billion annually.
Still after buying those assets
you would have 1 trillion U.S. dollars in cash leftover."
Buffett explains that a century from now,
the 400 million acres of farmland
will have produced a massive amount of output
regardless of the currency regime at the time.
Exxon will have produced trillions of dollars
in profits for shareholders
while also growing its assets
to be worth many more trillions.
The gold on the other hand,
will have remained unchanged in size
and will still be unable to produce anything.
As Buffett elegantly describes it,
"You can fondle the gold, but it will not respond."
Buffet's argument makes logical sense,
but let's see how it holds up in the data.
In a 2012 paper, titled The Golden Dilemma,
Claude Erb and Campbell Harvey
examined some of the commonly held beliefs about gold.
First they looked at gold as an inflation hedge.
They looked at gold returns going back to 1975
when the U.S. came off of the gold standard
through March, 2012
and found that gold has not been a good inflation hedge
over the short or long-term
due to the volatility of its real price.
They did find that going back to the era
of Emperor Augustus, who reigned from 27 BC to 14 AD,
gold has been a pretty good hedge for inflation
measured by military pay.
So, if you have a liability due in 2000 years,
gold might be a good way to maintain your purchasing power.
Campbell and Harvey explain,
"In normal times,
gold does not seem to be a good hedge
of realized or unexpected short-run inflation.
Gold may very well be a long run inflation hedge.
However, the long run may be longer
than an investor's investment time horizon or lifespan."
Inflation hedging is only one reason that people buy gold.
I think it's probably even more common
for people to buy gold
because it is supposed to be a safe haven.
An asset that will do well
when everything else is doing poorly.
Erb and Harvey looked at this in their paper.
They found that 83% of the time
that stock returns were negative,
gold returns were positive.
I looked at them the data for the gold spot price
and the MSEI all country world index,
going back to 1988 through July, 2019.
They had a correlation of 0.085, which is very low,
but not negative.
We might expect a safe haven
to have a negative correlation with stocks.
In the calendar year, 2008
when the global market dropped over 40% in U.S. dollar terms
gold increased 5.53%, which is pretty good
but us government bonds increased nearly 14%.
It's not obvious that gold is always going to be there
to save the day when stocks crash.
But any asset with a low correlation to stocks
is worth consideration in a portfolio.
The big problem that I have with gold
even though it has a low correlation to stocks
is that it also has questionable expected returns.
As Buffett explained,
"This is not an asset with any output.
Gold will always be gold and it will be worth
whatever someone is willing to pay for it.
We may hope that it will maintain its real value,
meaning an inflation adjusted expected return of zero,
but historically it has had a very volatile real value."
Going back to 1988 through July, 2019
the standard deviation of gold spot price has been 15.43%
compared to 14.85% for the MSEI all country world index.
Over that same period, gold returned 3.43%
annualized before inflation
while global stocks returned 7.85% all in U.S. dollars.
Gold has been more volatile than stocks
while delivering low returns, not a great trade off.
I mentioned the detriment of gold's lack of expected returns
to portfolio construction.
Despite its low correlation to stocks,
its non-existent real expected return
makes it a challenging addition to any portfolio.
Going back to 1988 through July, 2019
I modeled a portfolio of 90% global stocks and 10% gold.
The portfolio with a gold allocation
had a slightly lower annualized return
than a 100% equity portfolio
but it did have slightly higher risk adjusted returns.
The diversification of uncorrelated assets at work.
It would be easy to stop here
and conclude that gold is useful in portfolio construction,
but every dollar allocated to gold
is a dollar that could have been allocated
to something else.
A portfolio with a 10% allocation
to one to five year global government bonds
hedged to Canadian dollars instead of gold
had higher returns and higher risk adjusted returns
than the 10% gold portfolio over the same time period.
In this example,
allocating to gold did offer a volatility reduction benefit
but there was also an opportunity cost
to allocating to gold in place of government bonds.
This example held true
over the single time period that I had the data to model.
But in terms of expected returns
we would anticipate it to remain true.
Gold as a non-cashflow producing asset
has no real expected return.
Gold may have historically done well
when stocks have done poorly,
but there were other diversifying assets
with better expected return profiles
that accomplish the same.
Erb and Harvey also point out that importantly,
being a safe haven on paper
does not make something a safe haven
for the actual wealth of the owner.
The concern, of course, is that in a true catastrophe
it is very hard to take your gold with you.
And a gold ETF will not be much use.
I don't think many people will disagree
that gold has been a bad long-term investment.
However, anyone who well advocates investing in gold
as part of a portfolio
is probably not thinking about it as a long-term investment.
Rather, they are thinking about it
as a long-term insurance policy
against catastrophic events like hyperinflation.
Harvey and Erb also looked at this insurance angle
in their paper.
They offer Brazil from 1980 to 2000 as an example.
Over that time period,
Brazil had an average annual inflation rate of about 250%.
And the real price of gold in Brazilian terms
fell by about 70%.
That declined and the real value of gold
roughly matched the real decline in the price of gold
faced by a U.S. investor over the same time period.
Erb and Harvey found that the real value of gold,
its purchasing power, remains about the same
around the globe at any given time.
From a Brazilian perspective over this time period,
gold was not as successful inflation hedge
in the sense that it lost 70% of its purchasing power
but it was certainly better than holding Brazilian cash
which lost nearly 100% of its value.
Does that make it a good hedge? Not quite.
The main takeaway here is that the real returns of gold
are unaffected by the inflation environment
in a given country.
Gold does not care about the currency inflation environment
and it may have substantial negative real returns
during a period of hyperinflation.
There is no reason to expect
that it will maintain its purchasing power
or deliver positive real returns
just because there was a bout of hyperinflation
in the country that you are in.
Gold is not a productive asset.
It has a real expected return of zero.
Meaning that based on history,
it might keep pace with inflation over the very long-term,
but the very long-term is probably longer
than most people can wait.
Even as a safe haven,
due to its low correlation with financial assets,
gold falls short in a portfolio
due to its non-existent real expected return.
Finally, while gold's purchasing power
is unaffected by inflation, that does not mean
that gold will maintain its purchasing power
during periods of inflation,
calling into question its ability to hedge
against extreme currency events.
One thing that I have not talked about is trading gold.
Some people will tell you
that it is possible to profit from actively trading gold
as opposed to holding it.
This may be true,
just as it is true for other nonproductive assets,
like Bitcoin.
But this channel is not about trading strategies.
I bet there are hundreds of YouTube channels
dedicated to teaching you trading strategies for gold
and I bet that none of them cite the academic literature
that we have discussed today.
I will let you draw your own conclusions about that.
Do you own gold in your portfolio?
Tell me why and how you own it in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
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