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Gold: And Then There's The Downside!

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Gold has had quite the roller coaster ride over the last five years. The unprecedented monetary easing policy taken by the Federal Reserve has made some investors unnerved about the threat of hyperinflation and the possibility of falling back into another - possibly more severe - economic calamity. Burned by the most recent stock market slide, investors are looking for alternatives, like gold, to bring their anxiety to ease. In fact, a Gallup poll published in April of 2012 found that 30% of respondents considered gold to be the best long term investment versus other traditional asset classes such as stock, bonds, and real estate.[i] But like all investment trends, merit should never be given based on short-term results. Thoroughly vetting an asset class should always be viewed from a much broader perspective.  

The run-up in gold has been quite remarkable. When the Federal Reserve first announced its decision to begin its quantitative easing strategy, gold was trading at  $820.50 per troy ounce[ii].  It subsequently climbed to over $1,895 per troy ounce[iii] at the height of its surge in early September of 2011, which is equivalent to a 35.18% annualized return and a 130.83% total return compared to the 14.31% annualized return and 44.45% total return of the S&P 500 – not bad at all!

Since its peak in August of 2011, however, it has precipitously fallen almost 30%, exposing the often-overlooked characteristic of commodities and precious metals – volatility! Going back to the inception of the London Fix Gold PM Index in 1973, the annualized standard deviation (measure of risk) for gold has been 20.41% per year, which is significantly larger than the 15.80% average annualized standard deviation for the S&P 500 over the same time period. And although gold's most recent run-up has been impressive, its luster becomes less attractive when examining its long-term performance.

According to Bryan Harris of Dimensional Fund Advisors, "investors who think of gold as having strong long-term returns base their belief on two strong performance periods in the past four decades – the most recent decade and the 1970s."[iv] As seen in the two charts below, gold as an asset class (London Fix Gold PM) outperformed U.S. small cap stocks (CRSP 6-10), U.S. large cap stocks (S&P 500), international equities (MSCI World ex US Index), and a passively managed portfolio of global equities (IFA Index Portfolio 90) in real dollars (adjusted for inflation) during both the 1970s and the 2000s.


From 1973 - 1980, the real growth of $1 in gold grew to $4.48 versus $0.81 for the S&P 500.
In the 2000s, the real growth of $1 in gold grew to $4.19 versus $0.91 for the S&P 500, and although a portfolio of global equities (IFA Index Portfolio 90) has recently caught up with gold within the last few months, gold held a wide lead for the majority of the last decade.


Once we examine longer-term data, the case for holding gold becomes less appealing. The chart below shows the real growth of a dollar over the 40-year period ending December 31, 2012 for the same indices. 

$1 in gold grew to only $4.85 compared to other equity indices – 7.63% for the S&P 500 and $16.38 for IFA Index Portfolio 90. Further, the underperformance by gold over this period was accompanied by a 20.41% annualized standard deviation, which is substantially higher than the 15.80% and 15.71% standard deviations for the S&P 500 and IFA Index Portfolio 90, respectively.

What about protecting purchasing power? Although investors have ramped up their share of gold in hopes of evading upward monetary pressure on inflation rates, gold has never been an absolute success in protecting investors from its effect. The chart below shows the real return for both gold, a representative index of the entire market of domestic equities (Wilshire 5000), and the Consumer Price Index (industry measure for inflation). 

As you can see, gold has not been able to keep up with the CPI for the majority of the last 40-year period, while equities produced a positive real return, suggesting its reliability as a hedge against inflation to be more robust. This period includes three significant economic recessions and multiple wars and conflicts around the world.

The last thing to consider, especially in the context of an entire portfolio for a long-term investor, is the diversification benefit from holding gold. The lower the correlation with other traditional asset classes (stocks, bonds, cash, etc.), the higher the diversification benefit.

The table below shows different iterations of IFA Portfolio 50 (a good blend of global equities and fixed income) with allocations to gold ranging from 5% to 20%, while keeping the allocation to bonds fixed at 40%. Annualized returns and standard deviation (risk) are given in real terms.


IFA Index
Portfolio 50

Gold Allocation

Gold Allocation

Gold Allocation

Gold Allocation

Annualized Return






Annualized Std. Dev.






Sharpe Ratio












In regards to return, the IFA Index Portfolio 50 with no allocation to gold produced the highest annualized real return of 9.85% over the 40-year period ending December 31, 2012 as well as having the highest standard deviation (9.56%).

The Sharpe ratio is a measure of risk-adjusted return. In other words, it measures how much return each portfolio produced for each unit of risk taken, above what investors could have earned for taking essentially no risk (i.e. a very low risk investment like U.S. 30-day Treasury Bills). A higher ratio indicates a more efficient use of risk in generating return.

As the table indicates, each portfolio that made allocations to gold produced better risk-adjusted returns (higher Sharpe Ratios) with the 15% allocation to gold having the best (0.53). This would indicate that gold could potentially be a good diversifier within a portfolio of global equities and fixed income.

The t-statistic is a measure of statistical significance. In this scenario, it is measuring whether or not the annualized returns of the IFA Index Portfolios with allocations to gold are significantly different than that of the regular IFA Index Portfolio 50. A t-statistic that is greater than 2 indicates strong statistical outperformance at the 95% confidence level (there is a 5% chance that we are wrong about this conclusion). A t-statistic less than two indicates no statistical significance between IFA Portfolio 50 with no allocation to gold and IFA Portfolio 50 with an allocation to gold.

By examining the t-statistics for each portfolio that has an allocation to gold, there is not a single t-statistic that reached the plus or minus 2 threshold of significance, suggesting that the performances of the portfolios with allocations to gold is statistically indistinguishable from that of the regular IFA Index Portfolio 50. In other words, making an allocation to gold did not add any meaningful benefit to a largely diversified portfolio of stocks and bonds.

Although gold has been the recent fad of the investment community at large, its longer-term performance has not indicated a substantial premium for investors. While many investors point to its recent performance as being an indication of a great investment for hedging inflation, circumventing economic crises, or as a diversifier within a portfolio, it would seem that these attributes do not properly categorize gold over a longer time period - especially when compared to equities.

The main point for investors to consider when thinking about making an allocation to gold is its speculative nature. Unlike corporations, who produce products or services and have earnings, gold's worth is based purely on supply and demand. Price appreciation is the only source of return, which is never certain and arguably more uncertain than a corporation's ability to generate earnings. The less and less that consumer demand for gold, the less valuable it is. Based on its inability to produce any source of output that is valuable or usable (agriculture from land, earnings, etc.) it does not have an expected return, either positive or negative. Equities, in contrast, have a positive expected return given a company's ability to produce earnings. History seems to support the latter asset class in rewarding investors for the capital they supply.

 Think twice before jumping on the bandwagon! 

[i] Saad, Lydia. 2012. "Still Americans' Top Pick Among Long-Term Investments." Gallup. April 27.

[ii] Price of Gold on the London Fix Gold PM on November 25, 2008.

[iii] Price of Gold on the London Fix Gold PM on September 6, 2011.

[iv] Harris, Bryan. "Is Gold Worth Its Weight in a Portfolio?" Dimensional Fund Advisors, June 7, 2012.