We’re currently in the midst of a global health pandemic and economic recession, have an impending presidential election, and have seen many economists speculate on the devaluation of the U.S. dollar. With all of this uncertainty facing investors at one time, it's natural that this question is on investors’ minds. Some proponents will make the claim that gold deserves a significant weighting in investors' portfolios. Gold's often-cited portfolio benefits include a strong long-term return, a hedge against inflation, and a portfolio diversifier. However, the evidence raises doubt about gold as an essential component in a portfolio. In examining the long-term return of gold when considering its addition to your portfolio, it's important to recognize that gold's price appreciation has been limited to unpredictable, isolated episodes of high demand. In fact, if you disregard the 1971-1974 period where US investors were unable to own gold directly, its long-term performance drops substantially. From January 1970 – December 2019, gold returned 7.81% annually, however, when we look at the return figures starting in January 1975, which is when the government removed ownership restrictions and U.S citizens were free to directly own gold for the first time, the annualized return gets cut to 4.79%. Investors often think of gold as a hedge against inflation. As Exhibit 1 shows, however, gold has been about 15 times more volatile than inflation. Over the period from January 1970 – December 2019, the annualized compound return for gold was 7.81% with a volatility of 19.24%. For comparison, the annual inflation rate has been 3.91% with a volatility of 1.29%. Investors may also consider whether an asset allocation to gold should be included as a part of a diversified portfolio strategy. However, it is important for investors to keep in mind that gold’s historical return and market correlation characteristics alone may overstate its potential value as a portfolio asset. Professor’s Ken French and Eugene Fama argue that much of the stock of gold is in the form of jewelry and other goods that pay a "consumption dividend." This dividend increases the current price of gold and lowers its expected capital gain return. But an investor who holds gold as a portfolio asset only expects to get the expected capital gain, which does not suffice to compensate for the risk of the asset. Given that gold’s only source of return is price appreciation caused by shifting supply and demand, this makes gold a speculative asset. If you put gold in a vault and wait a few decades, it will not produce anything, and its value will reflect the current spot market price. In fact, holding physical bullion may incur negative cash flows due to storage, insurance, and other costs. In contrast, a stock reflects ownership in a business enterprise that seeks to generate profits and produce more wealth. Investors who put their capital to work in the economy expect a potential return from cash flows and appreciation. Famed investor Warren Buffet summarized gold’s speculative nature, non-productive quality, and high opportunity cost in Berkshire Hathaway’s 2011 annual report – while the metrics referenced may have changed, the story remains the same: “Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?” The decision to own gold is often motivated by an emotional response to current events, leading to abrupt shifts in allocation strategy and failure to achieve capital market rates of return there for the taking. Investors may be better off allowing gold to fulfill their material desires, rather than including it as a component in their portfolio.
Exhibit 1: Performance Statistics, January 1st, 1970 – December 31st, 2019
