Investing In Gold - YouTube

- Gold is often viewed as a safe haven

that will protect you from inflation, market crashes,

anarchy and even the total failure of fiat currencies.

Gold is often cited

as having a negative correlation with stocks

and a positive correlation with inflation,

making it sound like an excellent diversifying asset

to hold in portfolios.

I'm Ben Felix, portfolio manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you why gold's glitter

does not earn a place in your portfolio.

Any investment can be placed in one of four main categories.

Cash flow producing assets, commodities,

currencies and collectibles.

Gold has some limited utility in industrial production,

meaning that it could be viewed as a commodity

and it may form a component of many collectibles,

but those are not what drive the demand for gold.

Gold is primarily used as a store of value.

People buy gold,

hoping that they can sell it for more later.

What gold is most certainly not

is a cashflow producing asset.

In a 2012 article,

Warren Buffett created an excellent analogy

to explain why this is important.

He explained that the world's gold stock at that time

was worth about 9.6 trillion U.S. dollars.

For that amount of money, explains Buffett,

"You could buy all of the crop land in the U.S.,

400 million acres with roughly $200 billion of annual output

and 16 ExxonMobils, each earning $40 billion annually.

Still after buying those assets

you would have 1 trillion U.S. dollars in cash leftover."

Buffett explains that a century from now,

the 400 million acres of farmland

will have produced a massive amount of output

regardless of the currency regime at the time.

Exxon will have produced trillions of dollars

in profits for shareholders

while also growing its assets

to be worth many more trillions.

The gold on the other hand,

will have remained unchanged in size

and will still be unable to produce anything.

As Buffett elegantly describes it,

"You can fondle the gold, but it will not respond."

Buffet's argument makes logical sense,

but let's see how it holds up in the data.

In a 2012 paper, titled The Golden Dilemma,

Claude Erb and Campbell Harvey

examined some of the commonly held beliefs about gold.

First they looked at gold as an inflation hedge.

They looked at gold returns going back to 1975

when the U.S. came off of the gold standard

through March, 2012

and found that gold has not been a good inflation hedge

over the short or long-term

due to the volatility of its real price.

They did find that going back to the era

of Emperor Augustus, who reigned from 27 BC to 14 AD,

gold has been a pretty good hedge for inflation

measured by military pay.

So, if you have a liability due in 2000 years,

gold might be a good way to maintain your purchasing power.

Campbell and Harvey explain,

"In normal times,

gold does not seem to be a good hedge

of realized or unexpected short-run inflation.

Gold may very well be a long run inflation hedge.

However, the long run may be longer

than an investor's investment time horizon or lifespan."

Inflation hedging is only one reason that people buy gold.

I think it's probably even more common

for people to buy gold

because it is supposed to be a safe haven.

An asset that will do well

when everything else is doing poorly.

Erb and Harvey looked at this in their paper.

They found that 83% of the time

that stock returns were negative,

gold returns were positive.

I looked at them the data for the gold spot price

and the MSEI all country world index,

going back to 1988 through July, 2019.

They had a correlation of 0.085, which is very low,

but not negative.

We might expect a safe haven

to have a negative correlation with stocks.

In the calendar year, 2008

when the global market dropped over 40% in U.S. dollar terms

gold increased 5.53%, which is pretty good

but us government bonds increased nearly 14%.

It's not obvious that gold is always going to be there

to save the day when stocks crash.

But any asset with a low correlation to stocks

is worth consideration in a portfolio.

The big problem that I have with gold

even though it has a low correlation to stocks

is that it also has questionable expected returns.

As Buffett explained,

"This is not an asset with any output.

Gold will always be gold and it will be worth

whatever someone is willing to pay for it.

We may hope that it will maintain its real value,

meaning an inflation adjusted expected return of zero,

but historically it has had a very volatile real value."

Going back to 1988 through July, 2019

the standard deviation of gold spot price has been 15.43%

compared to 14.85% for the MSEI all country world index.

Over that same period, gold returned 3.43%

annualized before inflation

while global stocks returned 7.85% all in U.S. dollars.

Gold has been more volatile than stocks

while delivering low returns, not a great trade off.

I mentioned the detriment of gold's lack of expected returns

to portfolio construction.

Despite its low correlation to stocks,

its non-existent real expected return

makes it a challenging addition to any portfolio.

Going back to 1988 through July, 2019

I modeled a portfolio of 90% global stocks and 10% gold.

The portfolio with a gold allocation

had a slightly lower annualized return

than a 100% equity portfolio

but it did have slightly higher risk adjusted returns.

The diversification of uncorrelated assets at work.

It would be easy to stop here

and conclude that gold is useful in portfolio construction,

but every dollar allocated to gold

is a dollar that could have been allocated

to something else.

A portfolio with a 10% allocation

to one to five year global government bonds

hedged to Canadian dollars instead of gold

had higher returns and higher risk adjusted returns

than the 10% gold portfolio over the same time period.

In this example,

allocating to gold did offer a volatility reduction benefit

but there was also an opportunity cost

to allocating to gold in place of government bonds.

This example held true

over the single time period that I had the data to model.

But in terms of expected returns

we would anticipate it to remain true.

Gold as a non-cashflow producing asset

has no real expected return.

Gold may have historically done well

when stocks have done poorly,

but there were other diversifying assets

with better expected return profiles

that accomplish the same.

Erb and Harvey also point out that importantly,

being a safe haven on paper

does not make something a safe haven

for the actual wealth of the owner.

The concern, of course, is that in a true catastrophe

it is very hard to take your gold with you.

And a gold ETF will not be much use.

I don't think many people will disagree

that gold has been a bad long-term investment.

However, anyone who well advocates investing in gold

as part of a portfolio

is probably not thinking about it as a long-term investment.

Rather, they are thinking about it

as a long-term insurance policy

against catastrophic events like hyperinflation.

Harvey and Erb also looked at this insurance angle

in their paper.

They offer Brazil from 1980 to 2000 as an example.

Over that time period,

Brazil had an average annual inflation rate of about 250%.

And the real price of gold in Brazilian terms

fell by about 70%.

That declined and the real value of gold

roughly matched the real decline in the price of gold

faced by a U.S. investor over the same time period.

Erb and Harvey found that the real value of gold,

its purchasing power, remains about the same

around the globe at any given time.

From a Brazilian perspective over this time period,

gold was not as successful inflation hedge

in the sense that it lost 70% of its purchasing power

but it was certainly better than holding Brazilian cash

which lost nearly 100% of its value.

Does that make it a good hedge? Not quite.

The main takeaway here is that the real returns of gold

are unaffected by the inflation environment

in a given country.

Gold does not care about the currency inflation environment

and it may have substantial negative real returns

during a period of hyperinflation.

There is no reason to expect

that it will maintain its purchasing power

or deliver positive real returns

just because there was a bout of hyperinflation

in the country that you are in.

Gold is not a productive asset.

It has a real expected return of zero.

Meaning that based on history,

it might keep pace with inflation over the very long-term,

but the very long-term is probably longer

than most people can wait.

Even as a safe haven,

due to its low correlation with financial assets,

gold falls short in a portfolio

due to its non-existent real expected return.

Finally, while gold's purchasing power

is unaffected by inflation, that does not mean

that gold will maintain its purchasing power

during periods of inflation,

calling into question its ability to hedge

against extreme currency events.

One thing that I have not talked about is trading gold.

Some people will tell you

that it is possible to profit from actively trading gold

as opposed to holding it.

This may be true,

just as it is true for other nonproductive assets,

like Bitcoin.

But this channel is not about trading strategies.

I bet there are hundreds of YouTube channels

dedicated to teaching you trading strategies for gold

and I bet that none of them cite the academic literature

that we have discussed today.

I will let you draw your own conclusions about that.

Do you own gold in your portfolio?

Tell me why and how you own it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is Common Sense Investing.

If you enjoyed this video, please share it with someone

that you think could benefit from the information.

Don't forget, if you have run out of Common Sense Investing

videos to watch, you can tune in to weekly episodes

of the Rational Reminder podcast

wherever you get your podcasts.

(upbeat music)