Should you ever invest in gold? If so how much?

The price of gold has recently been in free-fall plummeting to a five year low (see chart below of performance for the year to date). Those trying to rationalise the rout are citing a rising dollar (gold is denominated in dollars so a strong dollar makes it expensive to buy), lower demand from China and improving investment market confidence. Yet gold's price has been falling since late 2011 so it's nothing new. Is the old investment adage of always holding a certain amount of gold as an insurance against market volatility even true. Should you ever invest in gold?

Why the world is obsessed with gold

Gold has held humans entranced for centuries. Part comes from its beauty and much from it's relative scarcity and the fact that it is chemically uninteresting. By the latter I mean that it doesn't react with anything which is always a good thing if you want to make coins and jewellery out of an element. It's therefore no surprise that it is deemed the most valuable of all the elements. But just how scarce is gold? It is estimated that if we collected every tiny piece of gold we've mined and melted it down it would all fit into a 20 metre cube!

Beyond jewellery gold has limited other uses. It is no longer used as a currency, something which ended when Richard Nixon cut the US dollar's tie with gold. Previously currencies were backed by gold, which is what gave them their value. You had to have gold in your vaults to back up the money you were printing. But the lack of gold meant that supply was running out. So to ensure that you can produce enough of your currency to keep up with economic demand it makes sense to ditch the gold standard. So from that point on money was worth the value written on it just because the Government said so, plus they were free to print as much as they wanted.

The price of gold throughout history

This was a crucial time in gold's history as it meant that Government's didn't have to hold on to huge amounts of gold. Yet while demand continued to grow the supply of gold didn't because you still have to mine it. So the price of gold started to become increasingly volatile. The chart below (click to enlarge) shows the historic price of gold over the last 750 years up to 2011. You can see the huge spike on the far right around the 1970s.

But as you can see the price of gold has been very volatile in previous periods of history, again due to lack of supply. Interestingly you can see the price of gold crashes in the 15th-16th Century which was when Christopher Columbus discovered large gold deposits in South America.

 

Investing in gold

Yet beyond it's limited uses gold is seen as an intrinsic store of value. In a world where currencies do not have to be backed by the precious metal the value of money fluctuates and is influenced by economics, financial stability and politics. As such a currency's value can be artificially inflated/deflated and can even swing wildly overnight. Remember what happened with the Swiss Franc when it appreciated by 40% in a single day in January this year!

Gold is often said to be a hedge against volatility and vulnerability in financial markets. So in times of uncertainty gold is often touted as a store of value. Warren Buffett, probably the most successful investor of all time, once famously said:

Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money, but the gold itself doesn’t produce anything.”

 

Is gold a good hedge against volatile markets?

Does gold actually work as a portfolio diversifier and act as insurance against a market collapse. If so how much gold should you buy?

To be clear, I am talking about investing in physical gold and not gold mining shares. Lots of gold funds actually just invest in the shares of mining companies and so are incredibly volatile, especially when markets have a wobble. Fortunately these days you can invest in physical gold by using certain Exchange Traded Funds (ETFs) which are physically backed. I cover this in more detail later in this article.

If an asset is to be a good diversifier it shouldn't be correlated to bonds or equities, which are the assets most DIY investors invest in. Fortunately there is a statistical measure that exists to measure whether two things are correlated (i.e whether they follow each other or not).

The table below shows this measure for 3 asset classes namely gold, UK equities and Bonds since January 2000. In that time we've had the dotcom bubble burst, the financial crisis as well as a host of other geopolitical events. A score of 1 would suggest that the two assets follow each other while a score of -1 suggests that as one rises the other falls and vice versa. A score of 0 means that the two assets are not correlated.

Asset	Gold Price	Typical UK Strategic Bond Fund	Typical UK Equity Fund
Gold Price	n/a	0.08	0.00
Typical UK Strategic Bond Fund	0.08	n/a	0.60
Typical UK Equity Fund	0.00	0.60	n/a

So the upshot is that while UK equities and bonds have a weak positive correlation (i.e. they tend to move in a similar direction more often than not) gold does its own thing.

A lesson from recent history

I painstakingly went back over time and recreated numerous portfolios assuming a different percentage of gold was invested in each, with the balance of each portfolio split equally between bonds and equities. The result of this analysis is shown below (click to enlarge):

 

The above chart would almost suggest that the more gold you hold the better. Yet if you overlay the price of gold on this chart you can see that the price of gold experienced a huge rally that skews the result somewhat when you simply look at total return over the whole period (click to enlarge).

 

However if you look at the period after the gold price peaked in September 2011 holding any gold at all was a bad idea (see chart below - click to enlarge)

 

How much gold should you hold in your portfolio?

To answer this we need to dig a bit more deeply and scrutinise the performance on a week by week basis rather than taking a single long term view. When you do the result is a bit more useful. The table below shows various statistical measures for each portfolio.

The key points to take from it are:

• Holding a small amount of gold reduces the volatility of your portfolio
• Gold is not a hedge against volatility as the more gold you hold the more volatile your portfolio.
• Holding gold reduces the size of your maximum losses to a point, yet holding too much will start to increase them again
• Holding more than 5% of your portfolio in gold starts to increase the frequency of your losses and reduces the frequency of your gains (as shown by the number of positive and negative weeks)

Portfolio	Max single fall	Max single gain	Max Loss	Negative weeks	Positive Weeks	Average annual return	Volatility
5% Gold portfolio	-24.94	11.31	-19.53	324	486	5.02	7.15
10% Gold portfolio	-21.71	14.75	-17.51	330	480	5.36	7.18
15% Gold portfolio	-19.24	14.13	-12.94	333	477	5.68	7.59
20% Gold portfolio	-17.38	17.34	-11.79	339	471	5.99	8.2
25% Gold portfolio	-16.18	17.26	-11.46	345	465	6.28	8.9
0% Gold portfolio	-35.34	13.72	-24.11	325	485	4.62	9.24
30% Gold portfolio	-15.82	17.18	-11.51	340	470	6.56	9.62
100% Gold portfolio	-38.03	20.55	-17.33	366	443	9.64	17.79

 

Should you ever invest in gold?

If you look at the charts above gold does not always rally when the market (indicated by the 0% portfolio) tumbles. So it is not a hedge against market falls. Neither is it a complete hedge against volatility as if you hold more than 25% of your portfolio in gold you actually increase your exposure to volatility.

However gold does well when everyone is in complete disarray and in fear of complete financial meltdown, as Warren Buffett alluded to above. That's what happened back in 2008 in the aftermath of the financial crisis as illustrated by the divergence of the portfolios in the first chart above. Numerous other geopolitical events in the following years in the Middle East and the eurozone kept the price of gold elevated. But since 2011 the price of gold has collapsed.

Holding gold in a market that is not in the grip of fear is painful. Despite the current concerns over a possible Greek exit the price of gold has been hammered, down 7% in the last week. Does that sound like a safe haven play to you?

Based on my research only buy gold to protect yourself from Armageddon but don't hold more than 5-10% if you plan to buy and hold it for the long term.  Use an ETF that physically holds gold such as the ETFS Metal Securities Ltd Physical Gold.

A better strategy altogether

But what would have happened if you'd used the momentum strategy that lies at the heart of the 80-20 Investor algorithm? The line in red speaks for itself! Click to enlarge the image.

 

 

 

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