Is Gold Worthy Enough To Mark A Place In Your Portfolio?

February 2nd, 2016

The benefits of investing in gold are often doubted in times of uncertainty in financial markets and weak global economy. The usual portfolio benefits of gold include gold being a safe haven, especially during turbulence, a promising long-term investment and a hedge against inflation.

Gold’s Long-Term Performance

Investors who believe gold to hold a strong long-term return base their belief on two strong performance periods in the past four decadence, with the 1970’s being the most recent one. This decade witnessed a major appreciation in Gold rates.

Figure 1 throws light on gold’s strong performance since 2000. After experiencing a twenty-year low in the year 1999, gold began to climb steadily in the wake of the 9/11 attacks, the Dotcom bust and the stock market downturn in 2001. Further down came the various natural disasters, Wall Street scandals, and record oil prices.

From the year 2000 through the year 2011, gold outperformed major equity asset classes around the world. In terms of real growth, gold increased the value of a dollar investment into $4.05 and US small cap stocks turned a dollar into $1.58. However, the S&P 500 Index and MSCI World ex US Index lost value.

 

Figure 1:

 

Figure 1
Now let us look back in time to the other strong decade for gold which is through the 1970s. Figure 2 highlights the performance of gold relative to equities after the US dropped its gold standard in the year 1971. A dollar of gold in the year 1971 experienced an appreciation to $8.91 in real terms by January 1980, when it reached its maximum peak at $850 per ounce, returning over 27% a year. Owing to this, gold saw a significant upward rise, thereby surpassing the performance of other assets.

Figure 2:

 

Figure 2
However, this volatile and rapid appreciation occurred under unique circumstances due to which the US investors could not benefit much directly. The reason behind this being the following:

  • President Nixon took the US off the gold standard, in August 1971, and the price was reset to $38 an ounce.
  • The US government decoupled the dollar’s value from gold, in 1973, and the price was allowed to have a free float.
  • During the year of 1974, the price of gold quickly shot up to $120 per ounce in the free market.
  • Beginning of the year 1975, the government removed the various ownership restrictions that previously existed and US citizens were free to directly own gold for the first time since 1933.

Hence, US investors were unable to participate in gold’s price appreciation during the first half of the 1970s, wherein gold performed at its peak. Later however, gold lost much of its glitter, as it was seen that from the year 1975 through 1980, the value of a dollar invested in gold grew up to a mere $2.37 as against a whopping $8.91, reflecting an 18.4% annualized real rate of return, being considerably less than the 27% return for the entire decade.

Some investors who retained the memories of the 1970’s associate the higher demand of gold with the turbulent economy. The decade of the 70’s was marked by wars, political unrest, two worldwide oil shocks, stagflation, Cold War tensions as well as the Middle-East conflict. In many ways, the 1970’s resembled the first decade of the century.

Surprisingly, this indicates that gold offered a relatively more reliable source of return during economic and market distress. However, the increasing demand for gold in the US was not merely out of economic uncertainty, but also due to the changing economic policies and federal legislation regarding individual ownership of bullion.

But looking at the performance of gold from a broader perspective, gold failed to deliver the expected long-term performance as imagined by some investors, especially during the more stable economic periods.

Figure 3 documents the real growth of a dollar that is invested in gold and equities from the year 1971 through the year 2011. Gold has provided a lower average return of mere 4.9% per annum and a lower inflation-adjusted growth than other assets of $7.33 per dollar invested as against a 5.3% for the S&P 500, 7.3% for US small cap stocks and 5.0% for non-US stocks.

Figure 3:

 

 

Figure 3

 

If one disregards the period from 1971–1974, when the US investors could not own it directly, gold’s long-term performance dropped substantially. From the year 1975 through 2011, gold gave out a real annualized return of only 1.82% and grew an invested dollar to only $1.95. US small cap stocks returned 10.6% ($41.73), non-US stocks returned 5.5% ($7.49) and the S&P 500 returned 7.1% ($13.07).

Now let us look at the twenty years between gold’s two high-performance periods, being 1970s and 2000s. Figure 4 shows growth of a dollar for the same asset groups, during gold’s period of extreme underperformance, from 1980 through 1999. Those decades are generally known for a positive stock market and global economic expansion. Despite favorable circumstances, gold delivered a -6.5% annualized return as against a 10.7% for US small cap stocks, 9.2% for non-US stocks and 13.3% for the S&P 500. Every dollar that was invested in gold dropped to 26 cents, in real terms, while the other assets grew substantially.

Figure 4:

 

 

Figure 4

Thus, when we look at the performance of gold from a long-term perspective, it is seen that gold has not experienced a reliable or sustained rise in value. In fact, its price appreciation was confined to volatile, unpredictable and isolated episodes of high demand.

Gold as an Inflation Hedge

Gold, as perceived by some investors, is a good hedge against inflation. Figure 5 below shows gold’s performance in both nominal and inflation-adjusted terms, from its price peak in 1980 through 2011. It is seen that gold’s price has increased substantially in nominal terms. But when adjusted for inflation, a dollar of gold in the year 1980 was worth $1.04 at the end of the year 2011.

 

Figure 5:

 

 

Figure 5
The performance of gold, relative to inflation, has varied according to the time frame measured. While in some periods gold outperformed inflation, in other periods, gold has failed to match it. Gold’s unreliable performance relative to inflation also suffers from much volatility. Gold’s standard deviation, since 1970, has been over 19%, as compared to 1.2% for the Consumer Price Index (CPI).By this measure; it seems that gold is over fifteen times more volatile than the CPI.

Gold as a Portfolio Diversifier

As believed and claimed by some proponents of gold, it offers a portfolio diversification benefit due to its low historical correlation with stocks. This may be true in a situation where gold is held as an incremental part of a broader diversified commodity strategy within a portfolio. But along with correlation, volatility is also a factor to be considered.

Also, as per the modern principles of finance, the components of a portfolio should have an expected return. However, gold, as a material input, does not offer the potential for generating significant earnings or income. Its only source of return is price appreciation which is caused by the shifts in demand and supply.

Owing to these characteristics, gold is quite of a speculative asset, like collectibles or currencies. If you buy net gold and keep it safely a vault and wait a few decades, expecting it to fetch higher returns, it most likely will rather just fetch you the current spot market price, which is absolutely uncertain and cannot be predicted. In fact, holding physical bullion may incur a negative cash flow due to insurance, storage, and other such costs. In contrast, investing in stocks reflects not only ownership in a business enterprise that seeks to generate profits but also eventually produces more wealth. Investors, who put their capital to work in the economy, easily expect a potential return from appreciation and cash flows.

Therefore, the above evidence raises doubts about gold being an essential component in a portfolio. Gold has failed to fetch the expected returns and deliver significant growth as compared to equities. While in real terms, gold has managed to preserve its value, but has proved to be more volatile than any other asset and failed to generate positive cash flow. Thus, gold failed to prove itself to be a potential benefit as a portfolio stabilizer as compared to equities and stocks.