Investing in Gold: Boom or Bust?
Gold reached a new record high of $2,074.50 per troy ounce on August 7th, its highest price since 2011. We therefore thought it a good time to provide an overview of gold, why some investors choose to own it, and why we’ve declined to purchase it in client portfolios.
Long-term investing generally involves owning a diversified mix of assets that are expected to maintain their value, pay income, or appreciate in price. In other words, a durable portfolio should be a combination of defensive and offensive assets depending on your risk tolerance. Most commonly, portfolios are comprised of stocks for offense and bonds for defense.
Stocks represent shares in publicly traded companies. In the short term, stocks tend to appreciate in price when economic news is bright and fall when the outlook turns gloomy. However, over the long-term, stocks generally increase in price, because companies create value over time. Historically, stocks have provided returns significantly above inflation, making them a key tool for portfolio growth.
Bonds, by comparison, tend to pay steady income, but they don’t generally increase in price like stocks. Bonds are contracts, and their future payments are defined in advance. This puts a constraint on price. Bonds typically become more attractive when the economic outlook takes a turn for the worse as investors seek out safer investments.
Some investors would argue that gold should also be included in a diversified portfolio. However, unless you’re expecting Armageddon, gold has proven to be less attractive than stocks or bonds in most economic scenarios.
Like a bond, gold is considered to be a hedge against bad times. Yet, unlike a bond, gold does not pay income. Like a stock, gold’s price is not bound by any constraints. Yet, unlike a stock, gold has no underlying business to drive long-term value. Gold’s value, like the value of any commodity (i.e. oil, soybeans, or wheat), is determined by supply and demand. Therefore, gold’s price can only appreciate if demand exceeds supply.
Demand for gold is supported somewhat by industrial uses, such as jewelry and electronics. However, this demand is limited, and it is not enough to support the prices we’re seeing today. Rather, gold derives much of its worth from being a store-of-value. People buy gold in the present so that it can be exchanged for goods and services later. In other words, gold is a type of currency. Demand for gold is driven primarily by its perceived worth relative to other currencies, such as the dollar or the euro.
The base investing case for gold is that it’s a hedge against economic catastrophe, like hyperinflation. If the United States were to enter a hyperinflationary period, then the value of the dollar would fall relative to other currencies, and gold would hold its value. Indeed, the price of gold would likely increase, because demand would outstrip supply. In such an environment, bonds would offer little protection, because they would be paid back with devalued dollars. Therefore, investors fearful of true economic catastrophe see gold as one of their only options.
Because of COVID-19, many people are scared. The economic outlook is uncertain, and it should come as no surprise that demand for gold has increased. The Federal Reserve has taken unprecedented actions to keep the economy afloat, including moves to keep interest rates lower for longer. This has shrunken the income that bonds pay, and it has made the dollar a less attractive store-of-value. As these competing investments have become less attractive, gold has become more attractive. Year-to-date, gold has increased in price by 31%, while the U.S. Dollar Index has declined roughly 3%.
Beyond the Fed, fiscal policy has also played a role. Outsized fiscal stimulus, including the $2.2 trillion CARES Act, has fueled inflationary concerns among a subset of investors who think that all this spending will devalue the dollar over time. Those investors have been buying gold.
On top of all this, a different subset of investors, called speculators, have been buying gold not as a hedge but as an offensive bet. They’ve hoped to make money in the short-term on the backs of fearful investors.
No doubt, gold has done well in the past few months. But how has it done over longer periods? For context, the ratio of gold to the S&P 500 Index is still 64% below its high point, which was reached in 2011. In other words, the S&P 500 significantly outperformed gold over the past decade. Over the trailing 10-year period ended July 31st, gold returned 5.32% on an annualized basis with a standard deviation of 16.9%. The S&P 500 returned 13.9% annualized with a standard deviation of 13.4%. Standard deviation is a measure of volatility, so this tells us that gold was more volatile than the S&P 500, and it provided lower returns. Over the past 20 years, gold outperformed the S&P 500, returning 10.3% compared to the S&P 500’s 6.3% return. However, gold was more volatile, with a standard deviation of 16.7% compared to a standard deviation of 15.0% for the S&P 500. Over the past 50 years, the S&P 500 has returned about 11% annualized with a standard deviation of 14.5%, and gold has returned 8.4% with a standard deviation of 17.4%. Over longer time horizons, stocks have historically offered the potential for higher returns with less volatility than gold, resulting in a better risk-reward trade-off and a better overall inflation hedge.
An argument can be made that gold should be held in portfolios for diversification purposes, because it tends to have a low correlation with stocks and bonds. It is true that gold sometimes provides a benefit within a broad portfolio context. However, gold can also languish for long periods of time, during which it provides no benefit. For example, from May 2013 to May 2019, the price of gold was essentially flat. It’s one thing for an asset to see no price appreciation for six years if it is generating income during that time, like a bond (or even a money market fund). But to provide no price appreciation and no income for six years is an unattractive proposition. Therefore, while there may be pockets of time during which gold provides a diversification benefit within a portfolio context, the rest of the time it simply creates a drag on portfolio returns.
We would also like to note what happened to gold during the last economic downturn, the Global Financial Crisis. Then, as today, goldbugs started to bid up the price of gold, because they feared economic catastrophe and because they expected the government’s fiscal and monetary policies to drive long-term inflation. Gold prices reached all-time highs before crashing 40%, once the economy stabilized and investors realized that inflation was largely contained.
In short, despite gold’s potential for strong short-term performance under the right circumstances, we’ve declined to hold it in client portfolios for many of the reasons outlined above. It is highly volatile, with trading patterns that are driven by speculation and fear. It can suffer agonizingly long periods of time where it provides no price appreciation and no income. It has little intrinsic worth aside from its role as an alternative currency; you can’t eat it, it’s not a major industrial input, and you can’t buy food with it at the grocery store. Lastly, its calling card is inflation protection, but stocks have generated better long-term returns with less risk.
As always, we’re happy to answer any additional questions you might have on this topic or others.