April 8, 2011
The case for gold investing has gained a lot of momentum recently. Since 2000, gold has outperformed most stock indices by a wide margin. The U.S. government’s high level of indebtedness and the political turmoil in various regions around the world have enhanced the perception that gold is a safe store of value. But is gold a viable asset class? Let’s examine some of the key arguments that are made in its favour.
1- High historical returns
This argument is at once true and false, depending on the period under review. If measured since the convertibility of the U.S. dollar into gold was abolished by the Nixon administration (1971), the metal has produced a high rate of return that almost matches the S&P/TSX Composite Index. But if we measure the return on gold since the January 1980 fever of gold speculation, then its rate of return is quite dismal. These two time periods are illustrated below:
In our view, the high return on gold for the 1971–2011 period seems fortuitous. Looking forward, we find no serious economic reason to believe that gold is going to provide returns that outpace inflation. Unlike stocks, bonds and real estate, gold does not produce any economic output such as profits, interest or rent.
2- Protection against inflation
This argument is valid only if the investor is able to tolerate an investment that can underperform inflation for several decades. While economic history teaches us that gold has kept its purchasing power over the centuries, our investment lifespan is quite a bit shorter than that. The nominal price of gold surpassed its 1980 record (US$873) three years ago. But in terms of inflation adjusted dollars, an ounce today is worth only 500 1980-dollars.
In our view, gold undisputedly provides diversification for a classic portfolio of stocks and bonds. Gold has had a low correlation with these asset classes: its monthly returns tend to fluctuate independently of those of stocks and bonds. Even better, gold has historically produced generous returns during extended stock-market droughts, as illustrated below:
In summary, of the three arguments in favour of gold investing, diversification is the clear winner. But diversification is of little use without the expectation of a significant positive return—net of inflation. We believe that gold’s positive returns in the last decade cannot be confidently projected into the future. Therefore, we would not advise that gold be included in an investment portfolio.
Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.