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A golden rule

To see this, I ran an experiment to see how the rule would have worked since 1990. At the end of each month, you hold gold if its price is above its 10-month average and one month Eurodollar deposits if it is below it. My table shows the results of this test.

How the 10-month average rule works
10-month averageBuy & hold
Annualised return5.134.55
Annualised volatility12.0015.70
Sharpe ratio0.430.29
Worst month-12.3-17.4
Worst 12 months-19.4-27.6
Based on returns in US dollars since 1990

It's clear that the strategy beats buy and hold. It earns slightly higher returns with less volatility.

It achieves this mainly by getting us out of gold before some big falls, such as in the late 1990s and in 2013. The worst-case losses for the 10-month average rule are smaller than for buy and hold, both for monthly and annual losses.

What's more, this rule combines well with its equity counterpart. In the late 1990s, the two told us to switch out of gold and into equities thus getting us into a rising stock market. And the two told us to get out of equities and into gold in the early 2000s thus getting us out of a falling asset and into a rising one.

However, the rule doesn't work all the time. From 1990 to 1996 its returns only matched those of buy and hold. And in the mid-2000s and in 2012 it actually underperformed buy and hold because it sometimes got us out of gold and so missed out on some rises.

There's a simple reason for this. The 10-month average rule fails when 'buy on dips' works. But it works well when there is momentum in markets - when rises lead to rises and falls to falls. It seems to be the case that, in gold, there is sometimes downwards momentum and the 10-month rule protects us when this is the case.

Here lies a nice coincidence. The 10-month average rule works in gold in much the same way that it works for the All-Share index. It gets us out of protracted bear markets and so increases our average profits by limiting our losses. This should increase our confidence in the rule's usefulness, as we have replicated its performance in a separate data set.

Right now, gold is some way below its 10-month average: it is $1,079 (£719.31) an ounce against an average in the past 10 months of $1,149. Our rule is thus telling us not to buy yet. Granted, following this rule might deprive us of some early gains if gold does pick up. But it also protects us from the possibility that the metal will continue to drop. And history tells us that, on balance, the benefit of the latter outweighs the cost of missing the first leg of any rally.