Updated: May 19, 2022
What role should gold play in a portfolio? Should it be considered an investment, a store of value (money), or as insurance?
"Although gold tends to maintain its value over the very long term, there can be sustained periods when it does not"
The great value investor Jean-Marie Eveillard said, "We don't look at gold as a commodity, but as a form of insurance against what Peter Bernstein calls extreme outcomes.
"In most circumstances in which worldwide equity markets would go down – and not just for a week or two – the price of gold would go up, providing a partial offset to the hits we'd take in our equity portfolio".
As far as long-term returns are concerned, gold has been a dreadful investment. Since 1920, the gold price in real terms has trended upwards by just 1.2% per annum. And you would not have wanted to leave it lying around so a good chunk of that 1.2% would have gone towards storage and insurance costs.
Throw in price volatility of close to 20% per annum and you are looking at volatility-adjusted returns perhaps 10x lower than those of equities.
Astute readers will point out that prior to 1971 the gold price was fixed and so real returns would have been a function only of inflation and the occasional price re-fixing. Thus to gauge what gold can do when subject to market forces one should look at the period since 1971.
The result? Real price trend growth of 1.1% per annum and volatility of 25.3%. These are hardly numbers indicative of a great investment.
A second feature that makes gold a poor investment is the difficulty in assessing its intrinsic value. It does not yield anything so you cannot perform a discounted cashflow calculation.
Looking at the marginal cost of production (MCP) as a way of evaluating downside can also be problematic. Why? Because the marginal cost of production can change materially over short periods.
You might think that the gold price is getting close to the MCP. But if sellers and excess supply continue to drive down the price, this may also drive out the marginal cost producers, in the process pushing down the MCP further.
And gold miners can also find ways to reduce their production costs, as indeed has been the case during the last few years.
For me, the best way to measure the intrinsic value of gold is to calculate the inflation-adjusted price – a reasonable approach in that one is assessing the price of gold in relation to the price of other goods and services – and to get interested when it gets to one standard deviation below trend.
And, perhaps more importantly, selling it when it gets one standard deviation above. This would have resulted in purchasing gold at the end of 1997 at around $300 and selling towards the end of 2010 at around $1,300, for a very tidy total return of over 300% or around 12% per annum.
You may think this would have been too early to sell, but a decent valuation framework would have had you put the money into equities which did just as well during the period when gold continued on to $1,900. Furthermore, you would have missed the last four years of gold price declines.
Where are we today? The gold price has fallen a long way, but is still 24% above trend.
As for buying gold as a store of value, it is abundantly clear from the numbers that although gold tends to maintain its value over the very long term, there can be sustained periods when it does not hold its value.
When gold was used as coinage it might have worked but gold coins went out as a formal means of exchange a very long time ago. And since Nixon took the world off the gold standard in 1971, gold now has even less of a link to money.
Which brings us on to the third possible use: gold as insurance. The best reason to own gold in your portfolio is if you think the so-called 'paper' money system that replaced the gold standard is fundamentally flawed and at some point will start to show cracks.
In this scenario, speculation about the need to return to gold would drive the gold price up sharply (and very likely the price of equities down).
What would cracks look like? Faith in currency, whether gold or paper, requires trust that the medium of exchange will retain its value.
In recent years, we have all been complaining that we do not get any income from our bank accounts, but it is not the end of the world in that inflation is close to zero.
However, if inflation started to rise sharply, this would damage paper money as a store of value, and if central banks did not act, the aforementioned speculation may begin to stir.
The good news is that the paper money system may be more stable than many doomsayers suggest. Despite some appalling behaviour by many banks, it survived the financial crisis. Furthermore, regulations have since been tightened, capital ratios improved and banks are now stronger than they were pre crisis.
If paper is indeed stronger than gold, and governments and their central banks continue to operate responsible fiscal and monetary policies, you may not need that insurance policy.
Published in Investment Week
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.