In our philosophy piece, The Role of Gold in Staying Rich, I make the argument for keeping a small portion of your net worth in gold so that you always have money. Obviously, gold you hold to have money serves a different purpose from gold held in your portfolio to diversify assets. In this article, I will give a little background and then show the low correlation gold has with other asset classes, discuss why it is highly correlated in world market sell-offs, what your gold position should be, when to rebalance and what major world events should be heeded.
Gold, while extremely important as a form of wealth insurance and an asset diversifier, is not an earning asset. In fact, gold has a holding cost in the form of storage, insurance and the opportunity lost from not having that money at work in an earning asset.
In Chart I below, you can see the ratio of the total return from holding the Standard & Poor’s 500 Stock Index and gold from 1870 to date. During this time period the return on equities was greater than the return on gold except for three periods when gold outperformed stocks (the declining line indicates that gold outperformed the S&P 500 total return index). The first period was in the 1930s when the government devalued the dollar by raising the price of gold from $20.67 to $35.00 per troy ounce. The 1970s were the second period. Gold outperformed equities during the bulk of the decade, fueled by President Nixon’s closing of the gold window in 1971 and by the January, 1975 lifting of the ban on Americans purchasing gold. The third period is the current gold bull market which started in 2000. Despite gold’s outperformance of stocks during these three periods, the overwhelming and powerful effect of compounding on reinvested dividends in common stock suggests that equities should be a part of everyone’s portfolio.
In Chart II below, we show the price of gold from 1870 to date. Looking at this chart, it is immediately clear why equities outperformed gold over most of the period: the gold price was fixed, in terms of U.S. dollars, from 1870 until 1970. Thus, if we look at Chart III, the ratio of the total return of the S&P 500 to the price of gold for the period from 1970 to 2011 when gold was freely traded, we find an approximate outperformance by gold from 1970 to 1980; an underperformance from 1980 to around year 2000 and an outperformance by gold from 2000 to date. The overall result shows the return on equities was about the same as that of gold, admittedly an extremely volatile ride whether you were invested in either asset class.
Chart IV suggests why gold might be an important addition to a diversified portfolio of global equities and fixed income. Since gold has a very low correlation with all major asset classes,adding gold should improve the return/risk performance of the portfolio. Gold performs this function admirably when measured over long periods. However, many commentators criticize gold as not being a safe haven during sharp daily market declines. These critics overlook the impact of the margin call that is issued somewhere in the financial system when the world markets are in panic mode. As the need to raise cash spreads, gold is usually among those assets sold first because of its liquidity and small transaction costs. Only later are illiquid assets reluctantly sold at reduced prices, if they can be sold at all. It is often said that in a panic market sell-off the correlation coefficient among asset classes approaches one, or perfect correlation. Based on our observation extending back over forty years, this has always been true. However, short-term panics should not dissuade the investor from the benefits of long-term diversification and low correlation.
These charts raise a couple of interesting questions. In a globally invested portfolio, what should the gold position be and when should you rebalance? We do not have a scientific answer to the first question, but based on historical return/risk relationships, we believe that a 5 to 10 percent investment in gold is sufficient to provide reasonable insurance against slow currency devaluation and price inflation. We think the question of rebalancing gold requires further analysis.
It is our view that currently in a world of fiat national currencies with no standard measure of value, domestic spendthrift pandering to the voter by the politicians, and increasing national debt, it is reasonable to conclude that selling gold to purchase more stocks and bonds might not be the most prudent course of action. Think of the hyperinflation in Zimbabwe[i]. If a portfolio manager had rebalanced by selling the portion of the portfolio allocated to gold, as the gold portion increased relative to the rest of the portfolio, it would have been a clear case of throwing good money after bad.
So how do you decide? Chart V illustrates that since the end of year 2000, the flight out of national fiat money currencies into gold has been truly astonishing. Yet this trend seems to draw almost no attention from the press. Is it coincidental that in this same period, for the most part, gold returns outperformed the S&P 500? Indeed, we hear that the current dollar bull market in gold is a “bubble.” Could gold decline in price? Yes, but against what? Perhaps the more appropriate question is, can the fiat national currencies rise relative to gold? We believe yes, under the condition that the real interest rate rises, making the opportunity cost of holding gold rise due to the lost interest on paper or fiat money.
This increase in the real rate of interest will also impact the stock market by an unknown amount—but historically, stocks have outperformed gold in periods of rising real interest rates. To see the past effect of rising and falling real interest rates on the relationship between the total return on stocks and gold go now to Chart VI. These data indicate that when the real interest rate was negative as it was during the 1970s and for most of the last ten years, gold outperformed stocks. If real interest rates were to move in a positive direction, especially if they were to become positive, then it is highly likely that stocks would perform very well compared to gold because of the opportunity cost of holding gold. In this case, we would be inclined to consider rebalancing away from gold to other assets. However, as long as the US Federal Reserve continues to maintain a near-zero short term interest rate and price inflation continues to be greater than 2%, gold probably should be held even if its value has grown beyond the target allocation due to relative price appreciation.
The fact is, nearly every major national currency has lost value against what more and more central banks and individuals are recognizing as the real money or currency—gold. We believe that in order to avoid destructive trade wars and capital controls there will be an attempt at a new “Bretton Woods” type agreement where the reserve currency status of the US dollar will be replaced by a currency basket, a portion of which will be gold. But in the end, this approach will also probably fail. It is rumored that the new world currency basket made up of fiat money from several countries and gold will be called the “Bancor.”[ii] Because all these countries will be inflating their currencies at different rates, it will produce a unit of account even more unpredictable than the US dollar.
Even though gold is not an earning asset, if you follow my three bits of advice below, you will always have money when needed and not be caught off guard.
- Hold a small amount of gold in coin to always have money.
- Hold gold as 5-10% of your portfolio because of its low correlation with other asset classes.
- Stay attuned to the international monetary situation. It is possible that some governments, unwilling to reward the “speculators,” will attempt to confiscate your gold at the then-current market prices prior to the creation of the new reserve currency.
[i] In economics, hyperinflation is inflation that is very high or out of control. While the real values of specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases rapidly as the functional or internal currency, as opposed to a foreign currency, loses its real value very quickly, normally at an accelerating rate. Hyperinflation becomes visible when there is an unchecked increase in the money supply usually accompanied by a widespread unwillingness on the part of the local population to hold the hyperinflationary money for more than the time needed to trade it for something non-monetary to avoid further loss of real value.
Zimbabwe is the first country in the 21st century to experience hyperinflation. The collapse of the Zimbabwe economy began shortly after destruction of productive capacity in that country’s civil war and confiscation of white-owned farmland. In 2009 Zimbabwe abandoned its currency; at present in 2011 a new currency has yet to be introduced, so currencies from other countries are used.
Information derived from Wikipedia and Steve H. Hanke, Professor of Applied Economics, The Johns Hopkins University and Senior Fellow, The Cato Institute [ii] On April 13, 2010, a paper entitled "Reserve Accumulation and International Monetary Stability" by the Strategy, Policy and Review Department of the IMF recommended that the world adopt a global currency called the "Bancor" and that a global central bank be established to administer that currency. "Bancor" is the name of a hypothetical world currency unit once suggested by John Maynard Keynes. Keynes was a world famous British economist who headed the World Banking Commission that created the IMF during the Bretton Woods negotiations. The IMF report referenced above, proposed naming the coming world currency unit the "Bancor" in honor of Keynes.
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