In past Mindfully Investing articles I’ve described the three major asset classes: stocks, bonds, and cash. Of course, there are many other investing options and gold is a popular one. Portfolio Charts analyzes 18 investment portfolios recommended by various finance big-wigs, and four of those have a substantial allocation to gold. Should you include some gold in your investment portfolio?
First, I should define gold, just like I’ve defined the other major asset classes. Obviously, gold is a precious metal that’s been used for thousands of years as decoration and money. Today, you can invest in gold two different ways. One way is to buy physical gold (like buying gold coins or bullion) and the other is buying funds that invest in physical gold. Gold doesn’t include investing in gold mining companies, which is just a type of stock investment.
It’s perhaps more helpful to consider how gold differs from stocks, bonds, and cash. Unlike these other asset classes, gold is not a financial asset. That is, gold is not a contract between the investor and an institution like a company or a bank. While stocks, bonds, and cash can increase or decrease in value due to price changes*, they can also pay the investor dividends or interest. In contrast, the only way you can make money from gold is when somebody wants to buy it from you at a higher price than you originally paid.
When you buy or sell something its useful to have some idea of that thing’s intrinsic value. Fundamental analysis of a company’s finances is one way to estimate the value of a stock. Perhaps an analysis of the fundamental uses for gold might help us measure its value. Gold’s main uses are:
- As a non-financial asset, which by somewhat circular logic, means that gold provides value to a bank or person simply because they know they can sell it to someone else at the prevailing price. In this simplest use, gold acts as a temporary store of value.
- A form of money, which means gold can be used for exchange instead of bartering. For most of history, you could give almost anyone in the world some gold and receive in return a horse, a plot of land, a keg of beer, or something else you could use or consume. And the person who received your payment could then use the gold in exchange for something else.
- A type of collectible or artwork, which means gold has value for mostly aesthetic reasons. The coins in the above photo have value well beyond their weight in gold because they’re historically significant and rare. And King Tut’s gold mask is mostly just an ancient work of art.
- A commodity, which is a broader category that includes all sorts of useful things from food staples (wheat, coffee, pork bellies, etc.) to other precious metals (silver and copper) to fuels (oil and natural gas).
The available supply balanced against the demand for a commodities’ fundamental uses causes prices to fluctuate over time. Gold has very few practical or industrial uses making it a unique commodity. The main demand for gold comes from its aesthetic appeal as jewelry. As Warren Buffet likes to say about gold, “It doesn’t do anything but sit there and look at you.” Or perhaps it’s more accurate to say that all gold does is sit there, while you look at how pretty it is. Warren Buffett and many other investors disregard gold, because the fickle demand of aesthetics entirely drives its value. But that’s probably not enough reason alone to completely ignore gold. Huge fortunes have been made (and lost) from the shifting aesthetic tides in fashion, music, writing, speech, visual arts, and style in general.
Gold as an Investment
As I’ve made abundantly clear at Mindfully Investing, the primary value of any investment is the return it provides over time. People sometimes also extol the virtues of investments with low volatility (small price gyrations). But because you can’t eat low volatility, it’s mainly just a side-show. The main act of investing is growing your money.
So, what are gold’s historical returns and expected future returns over an investing lifetime? I’ve covered this question for stocks and bonds elsewhere. (See here for historical returns, and here for expected future returns, which I update annually.) Because stock returns have a clearly superior track record to bonds and cash, mindful investing focuses mainly, but not exclusively, on stock investing. Perhaps gold returns can compete with stock returns.
When looking at returns histories, it’s often best to take the long view, like in this graph of real (inflation adjusted) gold prices from a presentation by researcher Claude Erb:
Remembering that gold returns are caused by price changes, this price graph shows that gold returns have varied greatly. There were long periods where you could have doubled your real money on gold (from about 1250 to 1500) and long periods where you could have lost 80% of your real money on gold (from about 1500 to 1950). Erb examines other evidence of gold’s value over the last 3,000 years and calculates an average annual return somewhere between 0.5% and 2%. In contrast, U.S. stocks have generated an average annual return of about 9% over the last 150 years.
Although they’re fun, return estimates across millennia are somewhat irrelevant to an investing lifetime, which is only 60 years at most. So, let’s look at the more recent history of gold returns from 1975 to present. Why that period? Prior to 1972, the U.S. government valued the dollar based on gold using the so-called “gold standard”, which made gold prices in U.S. dollars somewhat arbitrary. Also, ending the gold standard uniquely destabilized gold prices for a few years after 1972. Thus, I started this returns analysis in January of 1975 and compared gold returns to that of stocks (the total U.S. stock market) and bonds (10-year U.S. Treasury bond) using Portfolio Visualizer. The growth of an initial $10,000 investment is shown in the graph below in nominal dollars (not inflation adjusted). The blue line is stocks (Portfolio 1), the red line is bonds (Portfolio 2), and the gold line is, well, gold (Portfolio 3).
And here are some nominal return and volatility statistics for these three assets. I’ve also added cash in the last row for comparison purposes.
| Asset | Average Annualized Return | Volatility (Std. Dev.) | Worst Year | Maximum Draw Down |
| Stocks | 11.7% | 15.1% | -37.0% | -50.9% |
| Bonds | 7.3% | 8.3% | -10.2% | -15.8% |
| Gold | 4.3% | 18.8% | -32.6% | -61.8% |
| Cash | 4.6% | 1.0% | 0.0% | 0.0% |
If you invest in gold, you should prepare yourself for low cash-like returns, high stock-like volatility, and draw downs that would test the equanimity of the most adventurous investor. What’s not to love?
Why Some Investors Buy Gold Anyway
Given this track record, why would anyone want gold in their investment portfolio? In two posts, Charlie Biello at Pension Partners notes that gold is often used by investors as:
- A form of cash or currency hedge – Gold acts as a currency that can sometimes move against other currencies like dollars or yen.
- An inflation hedge – Gold prices often (but not always) increase when inflation ramps up.
- A stock hedge or “safe haven” – Gold prices often (but not always) increase when stocks crash or markets become volatile in general.
- An asset allocation tool – I’ve discussed before that a mix of two highly volatile investments can actually generate high returns with lower volatility than either individual asset. Gold can be used to improve “risk-adjusted” returns of stocks.
- Disaster (“tail-risk”) protection – If there is a global financial collapse of some sort, many people hypothesize that gold might maintain or even increase its value.
Biello points out that if you need these functions in your portfolio, there are more direct and reliable ways to access most of them. He shows in various charts and tables that:
- Gold is a poor currency hedge. Shorting a currency provides a much more predictable currency hedge.
- Gold is a sporadic inflation hedge.** Other less volatile assets can offer some inflation hedging too.
- Gold is uncorrelated (but not negatively correlated) with stocks. Many types of bonds have shown a greater negative correlation with stocks.***
- Adding other less volatile assets to a stock portfolio can also maintain portfolio returns and reduce volatility.
As for the fifth function, protection from huge economic disasters, Cullen Roche points out that “…in this Mad Max world, the man with the most gold won’t get the most bread. The man with the most lead will get the most bread.” And even in the case of more moderate economic disasters, Wes Gray notes that, in the 1930s the government confiscated gold and prohibited citizens from holding it in large amounts. He concludes, “I’m not a professional historian, but there is certainly precedent for the government taking over gold at the exact time when gold should have the greatest payoff.”
Gold as Portfolio Ballast?
Beyond Biello’s and Roche’s point that gold is not ideal for any of these investing functions, all these functions try to lessen the impact of a stock market crash or a wider economic crash. This is particularly true when you consider that stock markets often suffer from ramping inflation or a weakening home currency. These are all examples of the portfolio “ballast” function, where stocks are the main engine driving portfolio returns, and less volatile (and lower return) ballast such as bonds or cash can help dampen overall portfolio volatility.
The Mindfully Investing view is that ballast is mostly unnecessary, because it’s unproductive to worry about stock volatility. So, mindful portfolios are heavily focused on stocks, with some variations depending on how old you are. For investors near their retirement threshold, the Mindfully Investing conclusion is that holding about 20% ballast is reasonable, if the ballast is used properly.
How well does gold perform this ballast function? We can answer that question by comparing three portfolios composed of 50% stocks and the rest made up of ballast of either bonds, cash, or gold . Holding 50% ballast is unreasonably cautious for most investors. I’m using a 50/50 split here so that we can better compare how the various types of ballast perform. Here’s the Portfolio Visualizer graph of three portfolios starting in 1975 with a $10,000 investment. The blue line (Portfolio 1) is 50% stocks/50% bonds, the red line (Portfolio 2) is 50% stocks/50% cash, and the gold line (Portfolio 3) is 50% stocks/50% gold.
And here’s the table of return and volatility statistics. The last line shows a 100% stock portfolio for comparison.
| 50/50 Assets | Average Annualized Return | Volatility (Std. Dev.) | Worst Year | Maximum Draw Down |
| Stock/Bond | 10.4% | 11.4% | -25.5% | -38.0% |
| Stock/Cash | 10.1% | 12.0% | -33.1% | -45.8% |
| Stock/Gold | 10.1% | 14.2% | -33.2% | -46.6% |
| 100% Stock | 11.7% | 15.1% | -37.0% | -50.9% |
Gold ballast causes a drag on portfolio returns similar to that of cash and bonds. But in terms of volatility, gold is poor ballast, because it hardly reduces portfolio volatility as compared to the all stock portfolio. While you could use gold for portfolio ballast, it functions worse than using bonds or even cash, which begs the question, “Why bother?”.
Conclusions
Gold seems to be a mediocre investment by most measures. Since the end of the gold standard, gold has provided worse returns than bonds and slightly worse returns than even ultra-safe cash. Meanwhile, gold has been more volatile than stocks. While you can use gold to try to hedge against stock market crashes, resist the impacts of inflation, or to reduce portfolio volatility, gold is actually pretty bad at all these functions. Gold is a wacky sort of ballast that provides low returns combined with wild volatility.
All that said, I’m sure some readers may accuse me (at least in their thoughts) of cherry-picking my back-testing time frame. My rationale is that a longer time frame is better, and we only have useful data after the gold standard ended. Nonetheless, you can pick smaller chunks of time since 1972 that could lead to different conclusions. For example, look at the returns and volatility of stocks, bonds, gold, and cash since the year 2000, when I started seriously investing.
| Asset | Average Annualized Return | Volatility (Std. Dev.) | Worst Year | Maximum Draw Down |
| Stocks | 5.2% | 15.0% | -37.0% | -50.9% |
| Bonds | 5.1% | 7.4% | -10.2% | -10.2% |
| Gold | 7.8% | 16.7% | -28.3% | -42.9% |
| Cash | 1.6% | 0.5% | 0.0% | 0.0% |
For my entire investing life so far, gold provided by far the best returns. Gold did a great job of withstanding two major stock market crashes and a global near-collapse of the financial system, all while outperforming bonds during a historic bond bull market.
This is a good reminder of one of the four cornerstones of mindful investing: humility. While back-testing is useful and necessary, we understand that no future period will be exactly like the past. Markets, in gold or anything else, are inherently unpredictable. However, I would say that the history of gold is even less predictable than that of stocks, which have shown remarkable resilience for at least 150 years in the U.S. Because stocks are ownership in usually growing and productive companies, they’ve repeatedly bounced back from temporary crashes and into relatively long periods of superior returns. In contrast, the fickle aesthetics-driven demand for gold will likely continue to cause highly erratic returns into the future. Of course, you could speculate that gold will again outperform stocks and bonds in the next 20 years, but history suggests that’s only a blind gamble.
*In the case of cash, “price changes” occur relative to other cash currencies in the world.
**I’ve discussed elsewhere that many inflation studies have concluded that gold is the best of a bad set of inflation-hedging options. That is, gold prices increase during inflationary events more often than many other types of assets. Nonetheless, gold’s response to inflation has been variable and has sometimes failed to materialize entirely.
***Portfolio Visualizer indicates that, since 2000, gold and stocks have been uncorrelated at a value of 0.02, but the stocks and bonds have been negatively correlated at a value of -0.34. In recent history, bonds have been a better hedge against falling stock prices.
