Gold is shiny and makes nice jewelry, but it doesn’t impress me as an investment. It generates no earnings or income, which means you can’t reliably value it or assign it an expected return and volatility — and that makes it difficult to include in a thoughtful asset allocation. Rising inflation expectations and extraordinary levels of stimulus periodically boost enthusiasm for the yellow metal, so it’s worth thinking through the arguments carefully.
Gold Doesn’t Offer Much of an Inflation Hedge
Gold is commonly thought of as a store of value that hedges inflation, but that isn’t exactly true. Since gold futures began trading in 1975, prices have tended to rise in anticipation of higher inflation, and the real returns after that inflation does or doesn’t materialize have historically been poor.
One way to gauge gold’s effectiveness as a hedge is correlation, which measures how closely two variables move together. A good hedge would show a correlation close to 1.0. Yet from 1970 to 2020, the spot price of gold had only a 0.11 correlation to inflation as measured by the Consumer Price Index — awfully low for something supposed to be a hedge. Gold is also highly volatile, which is far from ideal for hedging something as stable as inflation.
Gold Feels Like an Obvious Diversifier, But Does It Stand Up?
There are generally two reasons to add a new exposure to a portfolio: to enhance returns or to improve diversification. The case for gold enhancing returns is essentially non-existent, because with no earnings or income there’s no reasonable way to estimate an expected return.
Gold’s correlation to both stocks and bonds is near zero, which can make it look like an obvious diversifier. But low correlation alone isn’t enough. A new exposure generally needs at least a 10% allocation to meaningfully improve a portfolio’s risk-adjusted returns, and each additional exposure carries a diminishing marginal benefit. Because I’m more concerned with implementing a bad idea than missing a good one, I’m not a believer in gold as a diversifier.
Using Gold to Bet Against Paper Currencies
Fears that a government will ruin its currency run throughout financial history, but U.S. investors should know it’s extremely unlikely the dollar is about to lose its value or reserve status. The euro lacks common fiscal and monetary policy, Japan doesn’t want the yen to become an international currency, and China’s yuan accounts for less than 2% of global payments versus the dollar’s 38%. U.S. markets are broad, deep, and transparent, and there is currently no real substitute for the dollar as the global reserve currency. Even if a second reserve currency eventually emerged, it would take decades to play out.
Using Gold as a Last-Ditch Hedge Against Bad Events
Some investors still see gold as the ultimate hedge against a really bad event. But you’d have to define what that event is and confirm gold would actually help — and buying gold in anticipation of it sounds a lot like market timing, which research consistently shows harms returns.
Market downturns happen on a regular basis. Rather than predicting the timing or cause of the next crisis, you’re better off planning for downturns of similar magnitude and frequency to the past. Investors must be willing to lose money on occasion to earn the long-term returns that attract them to stocks in the first place. Volatility isn’t the enemy; it’s the cost of the higher expected returns stocks offer over bonds or cash.
If you want a small position for peace of mind, keep it small and know why you own it. And if you already have a thoughtful financial plan and portfolio in place, it probably addresses the concerns that made you consider gold to begin with.
