With inflation fears grabbing headlines, we are often asked whether this is a good time to buy gold. This comment provides our recommendation on how to think about gold in investment strategy.
As an investment, gold has generated a 6.5% annual return over the past 15 years (Exhibit 1). Broadly, this trails stocks but beats bonds. It can certainly play a role in the investor’s toolkit, but people often have major misunderstandings about it.
Does gold protect against inflation? Is it a safe haven in times of fear? Should it hold a permanent spot in a portfolio? And what’s the best way to own it?
Surprise! Not Reliable Protection against Inflation
When we look at how gold trades compared to other investments and economic sentiments (Exhibit 2), we find some surprising insights.
First, gold shows no statistically discernable relationship to inflation, whether measured as Core CPI or as CPI excluding food and energy prices. In fact, gold was actually negatively correlated to core inflation for this period, meaning that as inflation went up, the price of gold tended to go down more often than not.
This analysis is for a long period, including periods when inflation was benign. Maybe gold did better when inflation was spiking? We have not seen prolonged bouts of inflation in over 30 years, but a look back at specific periods of inflation (Exhibit 3) shows that in two of the three primary periods of inflation between 1970 and 1991, the price of gold went down.
Gold did perform quite well during the inflationary 1970s, which may have bolstered the assumption that gold fights inflation effectively.
Potential Benefit: Diversification, Particularly with Defense
Exhibit 2 also highlights that gold does not trade in the same way as most major investment groups, whether stocks, real estate trusts, or the US dollar. This lack of relationship brings diversification, which tends to be helpful to a portfolio over longer periods.
Notably, gold shows similar trading patterns to US government and corporate bonds, meaning their prices tend to move in the same direction. Bonds—particularly government and investment grade corporates—often perform best in times of investor anxiety.
This relationship indicates to us that gold may offer a return profile with defensive characteristics, in diversified portfolios.
The Challenge: Reliable Signals for Buying and Selling
The challenge to investing in gold is that it is driven heavily by sentiment, in our view, and not fundamental criteria.
The price of gold itself does not trade on a measurable, fundamental foundation. There is no earnings stream, no dividend, no eventual payout. The price simply reflects what people collectively think the future will bring.
Pinpointing when that sentiment will turn negative or positive is almost impossible to do reliably. We believe investors are better served by investing in vehicles that can be objectively measured and valued.
We seek to build portfolios with investment tools that bring clear, measurable contributions and inter-relationships, not guesswork. For this reason, we do not recommend fixed allocations to gold for defense.
How We Include Gold in Portfolios
So, gold can bring diversification, but it is difficult to value objectively.
We believe the best way to capture the benefits of gold is to invest in public companies that approximate gold pricing in a measurable way. This is why we include stocks of companies that mine and produce precious metals in our investment strategies.
As shown in Exhibit 2, miners and producers of precious metals including gold are highly correlated with bullion pricing. We consider them a reasonable proxy to bullion.
This is a reasonable compromise, in our view. While other forces can drive these stock prices, such as management decisions about operating the business, balance sheet issues, etc., we can usually buy, hold, and sell those stocks easily based on fundamental criteria.
A Word on Buying Bullion Directly
It is possible to buy gold bullion rather easily—at first glance. For the average investor, we do not recommend it, however, because it requires expertise. To avoid mistakes or even fraud, buyers need to understand the dealer market, insurance and storage requirements, and potential liquidity challenges. These risks are particularly true for gold coins and jewelry when doing transactions of meaningful size.
Gold as an investment receives a lot of attention when headlines threaten inflation or doom. The problem is that gold tends to be driven by emotion rather than fundamentals, rendering a disciplined approach to it problematic.
We believe gold is not a reliable inflation hedge, but rather a defensive tool for investing. For defense, however, rather than using gold, we prefer to use fixed income and other yield-generating investments because we can objectively evaluate their fundamental standing.
Stocks that move closely with the price of gold, however, offer a reasonable compromise, in our view. The intention is to add a defensive element to our equity investments by including them, while being able to buy and sell them according to our analysis of objective business criteria.
With this discipline, we seek to reduce the impact of emotion on client portfolios.