Investing in Gold

Source: Erb and Harvey (2013)

Following World War II, the Bretton Woods system sought to re-establish economic stability by pegging international currencies to the U.S. dollar, which was then convertible to gold at a fixed rate of $35 per ounce. This system combined the benefits of the gold standard with the flexibility needed to manage post-war economies. However, by the 1960s, inflationary pressures and increasing dollar liabilities made maintaining the gold price unsustainable. In 1971, President Nixon closed the gold window, ending the direct convertibility of dollars to gold. This decisive move marked the collapse of the Bretton Woods system, transitioning the world to a fiat currency regime and leading to significant fluctuations in gold prices.

Several major historical events have had a profound impact on gold prices. The 1970s oil crisis, combined with the end of the gold standard, led to unprecedented inflation and a surge in gold prices, peaking in 1980 before entering a prolonged bear market that lasted until the early 2000s. The 2008 financial crisis once again highlighted gold’s role as a safe haven asset, as economic instability drove investors towards tangible assets, pushing gold prices to historic highs (Arayssi 2012).

Gold has long been perceived as a robust hedge against inflation and currency devaluation. Historical studies have noted that gold preserves its value over extended periods, even amidst significant economic upheavals. Research by Baur and Lucey (2009) indicates that gold acts as a hedge against stocks on average and a safe haven during extreme market conditions, highlighting its stabilizing effect during macroeconomic turbulence. Erb and Harvey (2013) critically examined arguments supporting gold investment, particularly the notion of gold as a safe haven, and while not all arguments hold, they concluded gold still serves as an ultra-long inflation hedge.

Gold’s potential for portfolio diversification has been extensively analyzed. Jaffe (1989) emphasized that direct gold investments are more effective in reducing portfolio risk compared to gold stocks. Hillier, Draper, and Faff (2006)confirmed gold’s significance relative to other precious metals, reinforcing its inclusion in diversified portfolios. Michaud et al. (2011) provided evidence supporting small but significant gold allocations, ranging from 1-2% in low-risk portfolios to 2-4% in balanced portfolios, underscoring gold’s role in stabilizing returns during adverse market conditions.

Source: Michaud et al. (2011)

The relationship between gold prices and macroeconomic variables has been subject to extensive scrutiny. Studies show mixed findings about the influence of interest rates on gold prices. For instance, Baur (2011) identified a positive impact of lower short-term interest rates on gold prices but noted a negative impact from longer-term interest rates, additionally noting that gold is impacted by weaker currencies, but not necessarily serving as a hedge against higher consumer prices. Despite some discrepancies, a common conclusion is that gold tends to serve as a hedge during periods of high inflation and economic instability, providing some degree of protection against volatile market conditions (Richard O. Michaud 2011).

• In Gold and Gold Stocks as Investments for Institutional Portfolios by Jaffe (1989), the author reviews the diversification potential of gold and gold stocks within a traditional portfolio, finding that the independent returns of such assets have the possibility to increase the average returns of a portfolio.
• In Do Precious Metals Shine? An Investment Perspective by Hillier et al. (2006) the authors review the empirical evidence surrounding precious metals’ (gold, platinum, and silver) hedging characteristics.
• In Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds, and Gold by Baur and Lucey (2010), the authors analyze the prospect of gold being a protective asset during market turmoil in several different geographic markets. The analysis uncovers that gold is, on average, a hedge against extreme market conditions, though, highlights the time-sensitive nature of owning the asset in an investment portfolio during extreme environments.

• In Asymmetric Volatility in the Gold Market by Baur (2011), Baur finds that positive economic shocks increase gold’s volatility more than negative economic shocks. This result has the potential to be additive to a traditional investment portfolio.
• In The Golden Dilemma by Erb and Harvey (2013) address several of the inherent arguments for gold as an investment such as its inflation hedging ability, currency hedging ability, and several others. The authors find that gold holds the possibility to maintain purchasing power over the long-term, though, find that a significant portion of the empirical evidence supporting gold’s inflation hedging capabilities is skewed by 1979, when gold increased by over 100%. The authors also explore the change in demand and supply dynamics across central banks, geographies, and investment funds.

• In The Financial Economics of Gold – A Survey by O’Connor et al. (2015), the authors provide a comprehensive review on gold, the gold market, and gold as an investment.

• In Is Gold a Safe Haven in all Currencies? by Baur (2021), Baur reviews gold’s safe haven properties across 68 international markets and currencies. Importantly, Baur finds that gold acts as a safe haven in the majority of these markets, finding that the local currency’s strength/weakness can influence the precious metal’s effectiveness as a safe haven asset.
• In Gold, the Golden Constant, COVID-19, ‘Massive Passives’ and Déjà Vu by Erb et al. (2021), the authors review the empirical evidence behind gold as an inflation hedge, and the timing of gold investment given the current real price of gold.

• In Gold and the S&P500: An Analysis of the Return and Volatility Relationship by Kuck (2021), Kuck reviews both the conditional returns and volatility of gold when conditioned on US equity markets, finding that while gold’s returns are not strictly dependent on equities, the conditional increased volatility of gold during equity shocks may be detrimental to a portfolio, overall.
• In The Best Strategies for Inflationary Times by Neville et al. (2021) the authors survey a wide variety of investment strategies, asset classes, and individual assets to assess each individual response to inflationary regimes.

• In How to Use Gold as a Safe Haven by Baur and Dimpfl (2023) review the use of gold as a safe haven investment in both strategic and tactical context, finding that its use as a strategic investment is preferential due to the requirement of optimal timing in a tactical asset allocation framework.
• In The Golden Rule of Investing by Van Vliet and Lohre (2023) explore the place of gold in an equity-based portfolio with the purpose of reducing drawdown characteristics. The authors find that a modest allocation to gold in such a portfolio reduces drawdowns, at the expense of returns. The authors then analyze gold in the context of a low-volatility equity portfolio, finding a favorable pairing between the factor and commodity.

• In Is There Still a Golden Dilemma? By Erb and Harvey (2024), review the current environment of gold, considering the offering of gold from retail stores and central bank attitudes, and analyze the efficacy of gold given macroeconomic backdrops.

In this section we show the historical performance of gold using the spot gold price, in relation to global equities, US Bonds, and a balanced 60/40 portfolio.

Source: Bloomberg, FRED, Philadelphia Fed. Performance is backtested and hypothetical. Performance data begins in 1976 and ends in 2023 due to data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all distributions. Past performance is not indicative of future results. See Appendix A for index definitions.

Source: Bloomberg, FRED, Philadelphia Fed. Performance is backtested and hypothetical. Performance data begins in 1976 and ends in 2023 due to data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all distributions. Past performance is not indicative of future results. See Appendix A for index definitions.

Source: Bloomberg, FRED, Philadelphia Fed. Performance is backtested and hypothetical. Performance data begins in 1976 and ends in 2023 due to data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all distributions. Past performance is not indicative of future results. See Appendix A for index definitions.

Source: Bloomberg, FRED, Philadelphia Fed. Performance is backtested and hypothetical. Performance data begins in 1976 and ends in 2023 due to data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all distributions. Past performance is not indicative of future results. See Appendix A for index definitions.

Gold has long been recognized for its unique properties and potential benefits when incorporated into investment portfolios. From serving as a diversifier to hedging against inflation and currency risk, gold can play a strategic role for a variety of investors. In this section, we explore some of the key applications of gold in portfolios.

Below we show some examples of how one might contemplate use cases for gold in an investment portfolio.

If you’d like to explore any of these scenarios, please visit the Return Stacked Tools site to find tools to test and visualize these ideas in an intuitive framework.

Enhancing Portfolio Diversification

One of the primary benefits of including gold in a portfolio is its ability to provide additional diversification to a traditional portfolio. As a potential diversifier, gold hold a low average correlation to stocks and bonds and has empirically shown to reduce portfolio drawdowns during market downturns, on average.

As noted in the Performance History section, gold also has historically exhibited a positive Sharpe ratio in a “Growth Down / Inflation Up” economic regime, when stocks and bonds tend to underperform. This outcome, however, as noted by Erb and Harvey (2013) may be greatly skewed by one year, 1979, when gold dramatically appreciated in value.

Hedging Against Inflation and Currency Risk

Gold is often seen as a hedge against inflation risk, due to its nature as a real asset. Erb and Harvey (2013) reviewed this potential use case, finding that over the ultra-long-term, gold can indeed act as an inflation hedge, however, shorter-term fluctuations in price levels had little-to-no-impact on gold price. That said, in the long-term, gold can be effective method of maintaining purchasing power.

Baur (2021) reviewed the potential for gold to act as a safe-haven asset in over 68 equity markets, finding empirical evidence that gold was beneficial in 60 of those markets. Additionally, Baur extended his analysis by reviewing the local exchange rate dynamics can impact gold’s potential as a safe haven. His analysis found that falling currencies can enhance the safe have effect, extending its potential outside of the United States, exclusively.