(Aug 28): Gold, gold, who would not like to have some gold? The very word is inextricably tied up with wealth and success: Think gold watches, gold chains and gold bars. We give gold away as dowry. We hoard it in our safes. But is it actually a good investment?

In my experience, gold is a love or-hate-it affair — there’s very little middle ground. There are those who dismiss it as a low-return asset suitable only for doomsday prophets awaiting the next financial collapse. But I also personally know several sophisticated investors who believe in it. Richard Fisher, president of the Federal Reserve Bank of Dallas, and clearly no fool, was cited by CNN in its 2012 article, “Stock picks from Fed officials”, as having more than US$1 million of his US$21 million portfolio allocated to gold, based on his financial disclosures to the Fed. So, the arguments for gold investment deserve objective consideration to sort the myth from reality. Here is what I found.

Gold offers low investment returns with high volatility
The chart tells us why most investors do not have a significant allocation to gold in their portfolio. Over the last 40 years from end-1976 to end-2016, gold returned a puny inflation adjusted 2%. In contrast, from 1978 to 2016, stocks returned an inflation-adjusted 6.6%, while even supposedly conservative bonds returned 3.3%. Over a longer time frame, economists Robert Barro and Sanjay Misra in their 2013 paper “Gold Returns” found even worse inflation- adjusted returns of 1.1% from 1836 to 2011.

It is no accident that gold has negligible real returns. Unlike stocks and bonds, it is not a generative asset. Most listed companies turn a profit which then increases the total value of the company’s shares over time. Most bonds, when held to maturity, will reward the investor with a higher value than when they were first issued, to compensate for the risk of default. But, like most commodities, gold generates nothing — it changes hands at a price based only on supply and demand. If supply and demand were to stay the same, the price of gold would stay the same forever (adjusted only for inflation), which is indeed close to what we have observed.

These poor returns would not be so bad if the price of gold was extremely stable. But, the fact is, gold prices are extremely volatile — more volatile even than stocks, as the chart shows. For those who are interested in growing their wealth in the long run instead of speculation, gold therefore offers the worst of both worlds — poor price stability and negligible real appreciation.

It is not a very effective hedge against inflation
Gold advocates might disagree with me on this one, but it all depends on how one defines an inflation hedge. One might say gold is an inflation hedge because it rises at the rate of inflation in the long run. But, to me, that is not enough. A hedge needs to adjust with inflation relatively quickly and reliably to be considered effective. An example of such an asset class is treasury inflation- protected securities, which are bonds that rise in value with inflation. Gold is nowhere as responsive and reliable as a hedge: While gold prices may grow at roughly the inflation rate in the very long run, they are far too volatile in the short run. So, a spike in inflation might well be accompanied by a period of falling gold prices and vice versa.

One possible exception is the scenario of hyper-inflation. The oftcited example was during Germany’s hyperinflation of 1919 to 1923, when prices were doubling at an average of once every 28 hours, according to Casey Research in its 2012 article, “Does gold keep up in hyper inflation?” Casey Research further calculated that gold prices not only kept pace during that period, but grew 1.8 times faster than the inflation rate. But gold’s behaviour in the previous example is not a given. As a counter example, economists Claude Erb and Campbell Harvey calculated in their 2013 paper “The Golden Dilemma” that gold ended up losing 70% of its value in local currency terms during Brazil’s hyperinflation of the 1980s. That is, of course, still much better than holding Brazilian currency, but a 70% loss is clearly not a very effective store of value.

It does provide some portfolio diversification, but potentially at the cost of returns
Gold prices have been shown to move independently of both stock and bond prices. Based on the same returns data as in the chart, in the past 40 years, correlation between yearly returns of gold and equities has been -0.01, which is to say, negligibly low. Gold is also slightly negatively correlated to bonds, with a correlation coefficient of -0.09. As such, gold can potentially help to reduce the overall volatility of a portfolio.

However, for this diversification impact to be significant, the allocation to gold would probably need to be quite large. And since gold has relatively low long-run expected returns, there is a substantial cost to pay in terms of lower returns for the reduction in portfolio volatility.

It is not a very reliable safe haven
The “safe haven” property of gold has been much touted: In times of economic turmoil, investors are said to rush towards certain
assets, such as gold, to reduce their risk exposure. Therefore, the argument goes, it is worthwhile to keep some gold as it will maintain or increase in value during times when equity prices are crashing.

But is this really true? One way to get at this question is to examine the behaviour of gold prices during periods when equity prices plunged drastic ally. Based on data provided by Macro trends Research and the World Gold Council, between 1979 and 2017, there were a total of 30 occasions during which the Standard & Poor’s 500 Index dropped 5% or more in a week. Of these 30 observations, gold prices in US dollars decreased in 17 of those weeks and increased in only 13, with the median being -0.2% — that is to say, close to zero.

Whether this behaviour constitutes an effective safe haven again depends on how low one wants to set the bar. For myself, an asset would need to have a significantly better-than-even chance of responding to a negative equity shock with a positive price movement to be considered a safe haven. This is clearly not the case here. Instead, the data above suggests that gold prices move independently of equity prices in times of stress, just like they do in more “ normal” times. In other words, to me, gold is better classified as a diversifier (moves independently) rather than a safe haven (moves in an opposite direction from equities).

When all is said and done, I find most of the arguments for holding gold quite weak, with the possible exception of its function as a rather expensive portfolio diversifier and perhaps as a store of value during hyperinflation. Instead, the most likely reason many investors trade gold is for purely speculative purposes. One can make stunning profits doing this, but remember that this is a zero- sum game for which retail investors, having less expertise, are likely to be on the losing end (the same warning applies to crypto currencies, by the way).

If Fisher, the Dallas Fed president, had indeed been speculating and he has held his position till now, then his US$1 million gold exposure at end-2012 would be worth only about US$750,000 as at end-July this year, a 25% loss. Surely something to think about for those tempted to invest in assets mainly for speculative purposes.

Herbert Lian is an independent financial advisory representative at IPP Financial Advisers. The views expressed here are solely those of the author in his private capacity. This article should not be regarded as professional investment advice or as a recommendation regarding any particular investment.