Gold: Safe Haven Or Shiny Distraction?
Gold is an effective inflation hedge if you plan on living for centuries
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Chapter 18: Gold: Safe Haven Or Shiny Distraction?
Gold is one of the most popular alternative investments to traditional portfolios of stocks and bonds.
There are two primary reasons investors buy gold.
It’s thought of as a hedge against inflation.
It’s seen as a “safe haven asset.”
In this chapter, we review the evidence of each of these claims and come to a clear decision about whether or not the rational investor includes gold in their portfolio.
The Golden Dilemma
The definitive research paper on gold is “The Golden Dilemma,” written by Campbell Harvey and Claude Erb1. In this paper, Harvey and Erb examine the value of gold over a 2,000+ year timeframe. It’s an incredibly detailed paper with some valuable findings of including gold in a portfolio.
Gold as an inflation hedge
Harvey and Erb found that gold tends to keep up with inflation and “hold its value over long periods of time.”
But just because gold holds its value over the long run does not make it an effective hedge against inflation. To understand why that is, you need to understand that for an asset to be a hedge against inflation; it must increase in value at the same time inflation rises to offset the impact of unexpectedly high inflation.
If gold is an inflation hedge and inflation is 6%, gold should rise by 6%. This is not how it plays out in real life because the price of gold is constantly moving up and down.
Harvey and Erb document gold’s ineffectiveness as a hedge against inflation from 1975–2011. To quote their findings:
“The price of gold swings widely around the CPI. The inflation derived price of gold and the actual price of gold have rarely been equal.”
Gold is an effective inflation hedge if you plan on living for centuries
A fascinating aspect of The Golden Dilemma paper is that Harvey and Erb examine the value of gold dating back to when Caesar Augustus ruled the Roman empire from 27 B.C. to 14 A.D.
The Romans kept meticulous records by ancient standards, so historians know exactly how much the Romans paid various ranking soldiers and military officers.
Roman legionaries (equivalent rank of a “private” in the U.S. military) were paid 2.31 ounces of gold a year, while a centurion (similar rank to a “captain”) was paid 38.58 ounces per year.
They found that when measured in U.S. dollars, Roman soldiers and modern soldiers in the U.S army were paid roughly the same amount.
This confirms two things:
When measured in centuries, gold has kept up with inflation.
Its long-run expected “Real” returns are close to zero.
Gold is not an effective hedge against inflation due to its short-term volatility, but if you plan on living for the next 2,000 years, it might be an effective way to maintain your purchasing power.
To quote Harvey and Erb:
“In normal times, gold does not seem to be a good hedge of realized or unexpected short-run inflation. Gold may very well be a long-run inflation hedge. However, the long-run may be longer than an investor’s investment time horizon or life span.”
Gold as a safe haven asset
The diehard gold investors view the asset as a “safe haven” investment; they believe gold will increase in value when traditional assets like stocks are crashing. The general idea is that when there is fear of a deep economic recession, people will flock to “safe” assets like gold.
Some of the most high-profile and diehard gold investors believe that gold will revert back to the primary means of exchange if the world economy comes crashing down. Let’s dispense with this line of thinking. The rational investor will always bet on the world not ending.
If you bet on the world not ending and you are right, you win.
If you bet on the world not ending and you are wrong, what’s happening with your portfolio should be of little concern.
Do you really think you’ll be dragging your gold bars around and exchanging them for food and shelter in a post-apocalyptic world? If so, you are reading the wrong book.
Even if you don’t expect to be shaving off a gold bar to buy eggs and milk, the question remains is gold a safe haven asset? Harvey and Erb provided two characteristics of what a safe haven asset might look like:
It should have a stable value during a “time of stress.”
It should be accessible to investors during that time of stress.
By those two characteristics, for gold to be a safe haven asset, it would need to hold its value, and investors should be able to get a hold of their gold and convert it into cash when they need it.
Harvey and Erb found that between 1975-2012 gold had negative returns in 17% of the months that the S&P 500 had a negative return. Meaning, for every five months, the stock market goes down, the price of gold also goes down. That implies a low correlation with stocks but not exactly a reliable “safe haven.”
On the issue of accessibility, Harvey and Erb point to anecdotal evidence to suggest physical gold is difficult to access during times of stress. Sometime around 400 AD, when the Roman empire was falling apart, a wealthy family buried their gold, and that gold remained buried until researchers unearthed it in 1992—nearly 1,600 years later. The fact of that matter is that gold is a heavy, physical asset giving it a low market value to pound ratio.
Gold does a poor job of satisfying either of Harvey and Erb’s characteristics of what a safe haven asset looks like.
Gold has no productive value
Warren Buffett made his thoughts on gold as an investible asset crystal clear in his 2011 letter to shareholders of Berkshire Hathaway2.
Buffett pointed out that gold has no productive value beyond its use in some industrial capacities.
To illustrate the non-productive nature of gold, Buffett made a comparison that at the time he wrote the letter in 2011, all the gold in the world—which at the time was worth $9.6 trillion, would buy:
400 million acres of farmland in the U.S with an output of about $200 billion annually.
16 Exxon Mobil’s with combined earnings of $640 billion.
While leaving $1 trillion in cash leftover.
Buffett asked what investor in their right mind would choose to own gold over those productive assets? Here’s his full quote:
“A century from now, the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be.
Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).
The 170,000 tons of gold will be unchanged in size and still incapable of producing anything.
You can fondle the cube, but it will not respond.”
Does the rational investor include gold in their portfolio?
Given gold’s popular narratives driven by enthusiastic supporters and its low correlation to the stock market, it’s easy to understand why many investors are happy to include gold in their portfolios.
However, the rational investor looks beyond narratives and examines the evidence. The best evidence available to us at the time I write this suggests that gold is neither an effective inflation hedge nor a safe haven asset. The real expected return of gold over the long run is roughly zero. This is because, as Warren Buffett points out—gold is a non-productive asset.
For all of these reasons, the rational investor does not include gold in their portfolio.
Erb, C. B., & Harvey, C. R. (2012). The Golden Dilemma. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2078535
(2011). Letter To the Shareholders of Berkshire Hathaway Inc [Review of Letter To the Shareholders of Berkshire Hathaway Inc]. Berkshire Hathaway Inc. https://www.berkshirehathaway.com/letters/2011ltr.pdf