For investors, 2022 continues to shape up as an unusually painful year. Stocks were down more than 20 percent over the first half of the year, and losses were even worse for the tech stocks that had previously led the market. Meanwhile, the Fed’s early moves to raise interest rates in addition to expectations for even higher rates in the future hurt the value of bonds. In turn, bonds have put up some of their worst returns in years, with the US Core Bond Index shedding roughly 10 percent for the first six months of the year.
Gold, along with commodities and cash, was one of the few places investors could hide. Gold has mostly drifted within a trading range in recent months (currently about $1,737 an ounce) but still qualifies as one of the higher-performing asset classes in the market route this year. But gold’s ability to enhance one’s returns over time is less clear even if its effectiveness as a portfolio safe haven is less black-and-white.
Gold as a Bear-Market Hedge
Gold has been a long-standing safe haven. The price of gold has little correlation to other asset classes and has historically been used as a safe haven against a weakening US dollar. It can also double as a hedge against inflation and market-risk.
There are basically two ways through which you can invest in gold: purchase the commodity (gold bullion) directly, or buy shares in gold mining companies (gold equity). As the gold stock has both financial and operating leverage, it serves to amplify the effect of changes in the price of gold. They are also much, much more volatile than bullion, which is only a proxy for underlying commodity price. In this article, I'll concentrate on gold bullion because it best suits investors interested in a hedge against market-related risk.
As noted already, gold has fulfilled its role as a buffer asset in this year’s market drawdown. Gold is down a little this year (as of shortly before the market opened on July 11, 2022), as a chart of the price of gold shows below, but it is still a buffer against much larger drops in stocks.
In the long-term, gold has always outperformed in bear markets and during times of abnormally high financial market volatility. Bottom line: As the chart below shows, gold has outperformed by a mile in previous market mini (and maxi) crashes. And while its performance during the novel coronavirus crisis did not provide a complete exception to the rule, gold has more typically achieved positive total returns during periods of pronounced losses in the equity market.
Does Gold Enhance Long-Term Portfolio Performance?
The trouble is, for as well as gold does in bear markets, its performance in all other market conditions leaves much to be desired. For instance, gold underperformed stocks for the majority of the 1980s and 1990s, for the most part posting negative returns on average during that time. It did well in the inflationary 1970s and the “lost decade” for stock returns in the 2000s, but it lagged behind stocks a lot beginning in early 2010.
The point of this all is: the performance of gold is bad because its nature of asset is different from others. As a commodity it doesn’t have any cash flows behind it, so it’s only worth what someone else is willing to pay for it. Central banks tend to buy gold reserves in times of economic uncertainty, as they did in the wake of the financial crisis, and that can support its price. (The price of gold can also be influenced by other shifts in supply and demand, like how much gold ever gets mined and how much of it is desired for jewelry and technology ingredients. It also has a cost in terms of opportunity cost relative to other safe haven assets Gold, for example, tends to do well when real (inflation adjusted) interest rates are negative and poorly when you can generate positive real returns on holding bonds instead.)
Is There a Benefit to the Long Term of Owning Gold?
Gold typically has served as a reasonable long-term inflation hedge, but there is no reason to think it will provide a positive real return in the long run. It’s an asset that doesn’t generate anything, so it lacks the capacity to produce economic value. (As Warren Buffett famously observes, it just sits there and looks at you.)
To see if gold truly does enhance long-term performance, I created four model portfolios using the allocations shown in the chart here. Gold’s volatility was so high that I peeled the gold allocations out of the equity side and kept the fixed-income holdings as is.
The Results
Gifted throughout the 46 ½-year trial period, quasi donating a portion of your assets would have slightly reduced returns. Gold is itself a risky asset; it experienced a maximum drawdown of 61.8% during the test period but its value lies in diversification. Gold has a history of low correlation to stocks and many of the other major asset classes; this low correlation helps to reduce risk at the portfolio level.
In other words, gold would have modestly added to the portfolio’s diversification and realized less downside for little gain in total return relative to the simple 60/40 portfolio not employing gold. On the whole, however, the uptick in risk-adjusted returns was fairly minor. It’s difficult to become too excited about a sharper ratio/ level 0.57/ rose either to 0.58 (at the 5% allocation), or 0.59 (at a 10 or 15% allocation). Those larger gold allocations contributed both to reducing drawdown risk and to weakening long-term returns.
Conclusion
The yellow metal has time and again demonstrated the value of being a safe-haven instrument and a portfolio diversifier. But in a portfolio context, its ability to boost risk-adjusted returns is just a little disappointing. All in all, gold is best regarded as insurance, and is best consumed in small amounts.
