Of all the investments in the Stockspot portfolios, gold consistently evokes the most passionate responses from our clients.
Views on gold as an investment polarise people but tend be more a matter of philosophy rather than fact. Since gold is a difficult asset to value, market commentators love to speculate what is causing the daily movements in the gold price.
As a result of the fixation by most people on short-term moves, little discussion seems to go into the value of owning gold as part of a long-term portfolio.
The purpose of this article is not to discuss what factors are currently influencing the price of gold but to explain why we recommend clients own some gold in their portfolios. There are some good reasons – but first, what makes gold such an emotional topic?
Why the controversy
Shares and bonds generate dividends and interest and this makes them reasonably simple to ‘value’ (theoretically at least). Gold on the other hand does not generate regular cash-flows so investors in gold can only benefit from capital returns.
Meanwhile, and unlike other commodities like iron ore or oil, there is little industrial use for gold. Gold doesn’t power our cars or enable the production of steel for buildings. Gold can’t be depleted or destroyed either.
The majority of the demand for gold in the world comes from either jewellery or investment. So when investors buy gold they are investing in an asset whose major use is simply as ‘an investment’ – and nothing else.
This apparent oddity has led famed investor Warren Buffett to once say about gold:
“Gold gets dug out of the ground in Africa …then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
It’s true that gold has few practical purposes and generates no return. However the value of gold does not come from its utility – but from its role as a store of value.
Gold as an alternative to money
Ray Dalio, who manages the world’s largest hedge fund (Bridgewater with US$169 billion of assets) strongly disagrees with Buffett’s assessment on gold, suggesting
“Gold should be a part of everybody’s portfolio to some degree because it is the alternative money.”
“If you don’t own gold…there is no sensible reason other than you don’t know history or you don’t know the economics of it”
From a returns perspective, gold has only performed slightly better than bank deposits over the long-term. However there is a more important reason why gold forms part of our portfolios – gold is a much better diversifier than cash – or any other readily investable asset class for that matter.
Gold as a diversifier
Gold is an excellent portfolio risk reduction tool. During times where assets like shares are falling, gold often rises, which helps to cushion the impact of sharemarket volatility. Equally when shares experience a strong period of growth, gold performs poorly.
Gold has a very low or negative correlation with most other investment assets which is why it often moves in a completely different direction to shares. This is a rare quality for an asset and it means that gold has the ability to reduce the risk of a portfolio without jeapordising performance. In finance-speak, gold helps to improve the quality of the portfolio returns which means you can earn the same return but by taking less risk.
Modern Portfolio Theory which was developed by Nobel Economics Prize laureates and forms the basis of our investment process states that investors can reduce the risk of investment loss by combining assets with low correlation into a portfolio. Since gold is the most negatively correlated asset to shares and bonds, it has an important role to play in this process.
Gold as an insurance policy
As well as being a proven portfolio risk reduction tool, gold also acts an insurance policy against currency devaluation. This is the situation where an investor’s home country currency loses its global purchasing power either because of economic factors (e.g. falling commodity prices in Australia) and/or a monetary crisis. In both cases owning some gold has historically been an effective way to help preserve the real value of your wealth.
For example, the gold price in Russian Rubles has increased 56% over the past 12 months because their economic collapse has caused the Ruble to devalue. Russian citizens who kept part of their wealth in gold have seen the value of that asset increase which would have helped to offset some of what they lost in Russian shares which tumbled 32% this year – and the Russian currency which has fallen by more than 50%.
Good as gold
Many people consider gold to be an old-fashioned relic with little modern-day value. It may therefore seem ironic that an online, automated investment service like ours would recommend that clients invest part of their portfolio in such an asset.
However, our analysis suggests that ‘alternative assets’ like gold serve an important purpose for any diversified investment portfolio. While there’s certainly no guarantee that the gold price will appreciate, gold improves the overall quality of portfolio returns through effective diversification, and provides a cushion when other assets fall.
Gold is the investment insurance policy you hope you don’t need to use – but are happy it’s there when you do.
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