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John Engle
John Engle
Articles (541) 

Can Investors Crash-Proof Their Portfolios With Gold?

A classic hedge asset has a complicated relationship with the stock market

November 12, 2018

Gold has always been seen as a classic hedge against inflation and market downturns. But how effective is it in those functions?

In this research note, we look at the performance of gold as a hedge against inflation and stocks, and compare its relative utility under various market conditions.

Hedge against inflation

Gold has been a popular hedge for a couple reasons. In normal times, it is thought of as a valuable hedge against inflation. But this function may not actually be all that impressive compared to simply using U.S. Treasury bills:

“Rightly or not, gold is widely viewed as an inflation hedge — a reliable measure of protection against purchasing power risk. The precious metal may not be the best option for that purpose, though. Some gold investors fail to consider its volatility as well as its opportunity cost, while others fail to anticipate storage needs and other logistical complexities of gold ownership. For these and other reasons, some view U.S. Treasury bills as a superior safe haven alternative to gold.”

Treasury bills may lack the romance and speculative value of gold, but they are also not nearly so volatile. As a hedge against inflation, an asset class with a speculative element built in may not be quite the best idea for the cautious investor.

If gold is not quite so ideal a hedge against inflation as some imagine, could it have other applications in less normal market conditions?

Hedge against stocks

Gold has also been a popular asset class among perma-bears and investors fearful of recessions or severe corrections in the market. Yet, as a tool for hedging this risk, gold yet again presents a mixed bag.

In run-of-the-mill bad months for the stock market, gold is a questionable hedge. Between 1986 and 2016, gold was up just 55% of the time during months when the stock market was down. The average return of the stock market across all these down months was -3.6% compared to an average return of 1% for gold.

That is a considerable difference, all things considered, but it is far from a conclusive argument in favor of holding gold.

Hedge against crisis

Gold only begins to shine (pardon the pun) in more extreme market conditions. Examining the 1986 to 2016 data once again, we can see that gold fares best when stocks are experiencing a full-blown rout. Of the 10 worst months for stocks in that time period, gold was up during eight.

But gold offers limited upside even in months of market panic. While the average return to the S&P 500 during these 10 worst months was -11.8%, gold saw a positive return of 0.8%. That is respectable by comparison, but it is hardly a hedge in a traditional sense.

Gold’s record during the past two bear markets was quite impressive, however. In the bear market of 2000 to 2003, gold rose 27.6% while stocks fell 42.5%. That looks like a real hedge after all. During the bear market following the 2008 financial crisis, stocks fell 51% while gold rose 18.6%.

Here at last we have a real use for gold as a portfolio allocation.

How to hold gold

Gold clearly has utility as a hedge, especially against severe market downturns. But that makes it something of a specialized tool, rather than a general hedge against one’s stock portfolio.

We can see gold’s inherent volatility at work in various pure-play gold exchange-traded funds. ETFs may also be tax disadvantaged, but at least they are tradable. One could trade in gold futures as well, but commodities trading is usually outside of a conventional investor’s wheelhouse.

Coins and physical gold have some advantages thanks to usually being taxed as collectibles, but they are extremely illiquid by and large. Additionally, playing physical gold in the form of coins can often lead investors to overpay vendors and middlemen, cutting into any potential returns (and thus weakening their power as a hedge).

Verdict

Ultimately, we see gold as a difficult asset. It may provide some hedge, especially in the most extreme situations, but it is far from a 100% perfect hedge against the market. Even as a hedge against inflation it is not great. But in times of extreme market stress, especially during the most recent bear markets, gold has performed admirably.

Thus, we see it as somewhat prudent for a small part of investors’ portfolios to contain some exposure to gold. In preparing for long-tail risks, it is always good to have exposure to (and direct access to) a known monetary commodity.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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