The Glitter of Gold—Should Gold Be a Part of Your Portfolio?
Gold is beautiful to look at and has a rich history, but does it belong in your investment portfolio? The information below will help you answer that question.
A Quick History
Gold has been valued throughout most of recorded history. It was used to display wealth, power, and status over 5,000 years ago in Egypt due to it rarity, aesthetic qualities, durability, and malleability.
The Lydians are the first culture to use gold as money, producing the first gold coins somewhere between 600 and 700 BC. It has played a role in global monetary systems ever since.
In the 1870s European countries adopted a gold standard that guaranteed they could redeem their paper currencies for an equivalent amount of gold. The US adopted the Gold Standard Act of 1900 establishing gold as the only metal that could be used in redeeming its currency.
The US abandoned the last vestiges of its gold standard in the 1970s. US currency is now backed by the “full faith and credit of the US government,” not by gold reserves. Today all the world’s currencies are “fiat currencies,” which means they are not backed by gold reserves.
Although gold is no longer used to back up any of the world’s currencies, it is still highly valued. In part, this is due to its rarity. It is estimated that all the gold that has ever been mined (approximately 197,580 tonnes) would fit into a cube about 69 feet on each side. On average, the supply of above-ground gold increases only about 1.5% annually through mining activity.
Gold has three main uses. Estimates vary, but about 47% of all gold is used in jewelry, 39% is held by central banks and private investors in the form of coins or bullion, and the remaining 14% is used for industrial or technology purposes.
The price of gold is driven by supply and demand. As we have seen, the supply of gold does not change much year-to-year. Changes in demand can be dramatic and may be driven by any or all of the three areas mentioned above—jewelry, investment, or industrial/technology.
What Role Should Gold Play in an Investment Portfolio?
Investors have mixed feelings about gold as an investment.
Some see it as a safe haven that can play an important role in preserving wealth during times of economic trouble and global strife.
Others see it as one of many commodities that can play a role in a well-diversified portfolio.
Still others have no interest in gold as an investment because of its relatively poor long-term performance history and high volatility.
All these views have some merit. Let’s examine each one.
Gold as a Safe Haven
Many articles written about gold as an investment refer to the precious metal as a “safe haven.” A safe haven investment is not the same as a “safe asset.”
Treasury securities, for example, are considered a safe asset. That is because they are backed by the US government and their prices are relatively stable compared to other asset classes.
Gold is different. It is considered a safe haven because people believe that it will hold its value and even, perhaps, increase in value during difficult times.
Difficult times is a catch-all term. It can include bear markets, periods of heightened uncertainty because of world events, concerns about a weakening dollar, the prospect of increased inflation, and even worries about the collapse of the global financial system.
Any occurrence or concern that raises investor anxiety can create increased demand for gold, as investors abandon traditional financial assets for the perceived safety of gold. This increased demand can drive the price of gold higher, thus reinforcing gold’s reputation as a safe haven.
The perception of gold as an enduring safe haven is driven, in part, by history and, in part, by the nature of gold itself. The Pharaohs of Egypt were amassing golden treasures all the way back to 3,100 B.C., while stocks and bonds did not come along until well over 4,000 years later.
Stocks and bonds have an ephemeral quality not shared by gold. They are intangible interests that can, and sometimes do, lose all their value. One-third of all companies in the Fortune 500 in 1970 no longer existed in 1983. On average, 3% of all corporate bonds default each year.
Gold is tangible and never goes out of business. It never misses a dividend or defaults on an interest payment. It doesn’t even corrode. If you put a gold bar in your safe at home, it will be there, unchanged, thousands of years later—long after both you and your home are long gone.
And gold has held its value well over time. In ancient Rome an ounce of gold bought a toga and a pair of sandals. Today an ounce of gold pays for a nice Italian suit and a pair of Gucci loafers.
It is easy to understand why gold is considered a safe haven by many investors.
Is Gold a Good Investment?
As a stand-alone investment, gold’s long-term track record is not particularly good.
Research published in The Economic Journal in 2015 by Robert Barro and Sanjay Misra found that from 1836 through 2011 gold earned an average annual inflation-adjusted return of 1.1%. By contrast, Barro and Misra estimated long-term returns over the same period to be 1% for Treasury Bills, 2.9% for long-term bonds, and 7.4% for stocks.
Research by Joshua Kennon of Kennon-Green & Co. looked at the amounts you would have received if you went back nearly 200 years and invested $10,000 in gold, bonds, and stocks.
Your $10,000 investment in gold would have more than doubled to $26,000. But your $10,000 investment in bonds would have been worth $8,000,000 and your investment in stocks would have been worth $5,600,000,000.
We looked at a more recent time period and found that gold lagged both stocks and bonds. Our research shows that between January 1987 and September 2020, gold returned 4.58%, while US bonds returned 5.94% and US stocks returned 10.27%.
Note that during this period, the volatility of these asset classes, as measured by standard deviation, was 15.10% for gold, 3.80% for US bonds, and 15.33% for US stocks. Gold returned less than US bonds, but was about as volatile as US stocks, which had far higher returns.
However, research published by Morningstar in July 2020 showed that over the last almost 50 years, gold has excelled during bear markets and periods of unusually high market volatility.
Gold as a Hedge Against Inflation
Gold has a solid performance record during down markets over the last 50 years, but, overall, its record during that period as a hedge against inflation is weak.
Research done by Morningstar shows that gold did serve as a hedge against inflation when inflation reached historically high levels in the 1970s. However, during the milder inflationary periods from 1980-1984 and 1988-1991 it showed negative returns and underperformed large cap stocks by a wide margin. Gold’s role as a reliable inflation hedge is questionable.
How Does Gold Impact Portfolio Volatility?
Gold can have a positive impact on overall portfolio performance characteristics. This derives from the fact that gold has a low correlation with stocks, real estate, and other traditional asset classes. But it’s record of improving portfolio performance is very time-period sensitive.
Research done by Morningstar shows that, over most time periods, adding gold to a portfolio reduces its volatility. Over some time periods it can also improve both risk-adjusted and absolute return. But over many others it does not. So, gold consistently reduces portfolio risk as measured by volatility, but often does not have a positive impact on portfolio returns.
How to Invest in Gold
If you want to add gold to your investment portfolio, there are three basic ways to do so.
You can own physical gold. This takes the form of either gold bullion or gold coins.
If you own physical gold, you must consider issues like storage, transportation, and insurance. These will add cost to your investment, but you control what you own. If the entire financial system collapses (it has never done so), you still have possession of your gold.
Instead, you can choose to own what is sometimes referred to as “paper gold.” Paper gold takes the form of financial instruments such as futures, options, or exchange traded funds. These instruments can be traded electronically, making them cheaper to maintain and more efficient to sell than physical gold. However, you are more exposed to financial system risks.
Alternatively, you can invest in stocks of companies that mine gold. These shares fluctuate in value with the price of gold, but tend to be somewhat more volatile than physical gold itself. These stocks may pay dividends, but, like paper gold, have exposure to financial system risk.
Is Gold Right for You?
As a stand-alone investment, gold has a poor track record relative to alternatives such as stocks or bonds, both on an absolute and a risk-adjusted basis. But in the event of serious meltdown in the global financial system, gold may play a role as a vehicle for the preservation of wealth.
Adding gold to a portfolio can play a role in reducing volatility and protecting against loss of value in down markets. The extent of these benefits will vary over different time periods. Gold’s record as a hedge against inflation is more questionable and time-period dependent.
Gold is not right for every investor. But, if you have a reasonable understanding of its performance characteristics, adding a modest amount of gold to a portfolio may provide risk reduction and even return benefits during some time periods.