Four questions every gold investor should answer

Pity that I’m not writing this column this time next year. Then I could begin with the observation that it is 100 years ago to the month since the world’s first celebrity economist famously labelled gold “a barbarous relic”. As it is, I’ll have to make do with the 99th anniversary and quibble that JM Keynes was actually referring to the gold standard as the relic, not the metal. No matter. His point was the same – the great man was questioning the obsessive notion that an intrinsically worthless metal (well, almost) could solve many of the world’s economic ills and certainly all those relating to inflation.

Ninety-nine years on, that obsession is as strong as ever. So strong that I am warming to the idea of gold as an asset class that should be in every serious investor’s portfolio. As to why, it’s partly a self-fulfilling prophecy. If enough investors believe gold is a must-have, since it responds favourably to the economic signals that crucify other assets, then – rational or not – that’s what it will be. The purchasing power of those investors will see to that.

Put another way, gold’s rare quality is that it has a special risk-reduction function. Of course ‘risk-reduction’ is a misnomer. It’s really about volatility reduction, which is similar but not the same. In the real world, almost by definition, risk must be about the possibility of a loss, since you can’t have the risk of a gain. Gains are what investors want so they can’t be classified as risks.

Not so, according to conventional portfolio theory. Gains are risky, says the theory, because they show up as variations from an average. The greater the variation, the greater the risk it carries, whether it is going the profitable way or taking the loss-sustaining route. This convoluted thinking is partly driven by the maths behind calculating variations around an average. But it also has some logic since high volatility – in whichever direction it is heading – adds to the uncertainty that investment targets will have been met at the point that holdings need to be cashed in. For investors, this is unsettling.

So, in the context of gold, four questions need addressing:

●  How risky is gold?

●  Does it reduce portfolio volatility?

●  Why are we asking these questions now?

●  Is the gold price currently in buy territory?

Gold’s reputation comes before it – that, for all its possible merits, it is a risky asset in the sense that its price bounces around a lot; maybe so much that it’s not worth the bother. Reality does not bear this out; at least, not according to data based on month-on-month price changes for the 55 years starting April 1968. That goes back to a time when the western world’s monetary policy still ran on something akin to the gold standard, when the US central bank stood ready to exchange its currency for gold.

The key points from the data are in the table. They show that the gold price rose much more often than US government bonds, but a little less than US equities. Despite that, gold’s average monthly change was the best of the three – 0.75 per cent compared with 0.67 per cent for equities, based on the S&P 500 share index of US stocks, and 0.36 per cent for US government bonds, represented by the 10-year benchmark.

Crucially, that superior performance was not accompanied by excess volatility. Standard deviation, which quantifies variation around an average, is portfolio theory’s favoured measure of risk and that shows gold as riskier than shares but less risky than bonds. That’s perhaps a surprising result. Intuition says bonds should be the least risky and gold may be the riskiest. But there it is.

However, one important caveat needs inserting. The numbers are measured solely by changes in capital values. Of course, with gold, that is all there is; but not so with bonds and equities, whose returns also come from dividends paid to holders. Add in those, and total returns would look very different. Gold’s total would remain unchanged, but returns for bonds and – especially – shares would be transformed, particularly if the calculation assumed that dividends were reinvested in the asset class that generated the payout. Then equities would be by far the best performer of the three. But that’s not necessarily the point. The question is about gold’s riskiness and the provisional answer is, ‘not that risky’.

Does that mean gold also reduces the volatility of a portfolio’s returns, arguably the chief reason for including it in a diversified portfolio? Theory says it should, and it is easy to understand where this notion comes from. It has everything to do with gold’s scarcity and immutability. The illustrative stats are readily available – for instance, throughout history little more than 200,000 tonnes of gold have been mined (by contrast, approaching 2mn tonnes of steel are produced every year) and almost all of it still survives, although less than 20 per cent in the vaults of central banks. Thus, in a changing and uncertain world, gold represents a store of value that can be relied upon.

As to the data, volatility reduction is measured by ‘correlation’, the statistic that quantifies the extent to which two sets of numbers move in the same direction. If they do, then the correlation is positive. If they don’t, which is what’s wanted if risk reduction is the aim, then the correlation is negative.

Ideally, in Chart 1 we are looking for chart lines that more or less move together and are sloping downwards or are in negative territory. That indicates that somehow gold’s price is, on average, moving in the opposite direction to both bonds and equities. Thus it is smoothing portfolio returns, trimming them when bond and share prices rise, but reducing the losses when those two fall.

Sure, as the chart indicates, the correlation between changes in the gold price in relation to both bonds and equities tends to move in the same direction. More or less, their price changes rise and fall together. And for much of the time since the early 1990s, the chart lines have been in an upwards direction, indicating that gold’s volatility-reduction function has been getting weaker. Granted, within the overall trend there have been significant diversions, such as in the early years of the new millennium when the correlation of gold to equities sloped steeply downwards. That indicates that gold’s resilience staunched some of the losses caused by three years of falling share prices. The correlation was much the same in the period 2016-18 except that gold’s losses trimmed some of the gains from equities.

However, over the entire 55-year period of the data, a ‘definite maybe’ seems a fair assessment of gold’s ability to smooth portfolio returns and thereby reduce risk. The correlation of gold price changes to both bonds and equities is positive, although by such a small amount that it seems fair to suggest that price changes between both pairs of assets are random.

Yet, despite this, it might still make sense to hold gold in a diversified portfolio. After all, runs the argument, the world is entering a phase of deepening uncertainty. The post-War global consensus based on the US’s rules is breaking down; a new and self-conscious superpower has entered the field; factors such as climate change, demographics and rising inequality add to the pressures; and blah-de-blah. The narrative is familiar. We hear it often enough. It might be sufficient to persuade us that immutable gold is the antidote.

But then the question is, even at current prices? This is where Chart 2 comes in. This shows the gold price since December 1969 translated from dollars to sterling and, more important, adjusted for the effect of UK inflation. In other words, it shows the real returns to UK investors from holding gold over the best part of two generations. The price has risen fourfold; adjusted to a base of 100, it was 532 at the end of March.

Assessing whether that makes gold currently cheap or dear is done by comparing its current price with its average over the whole period, as well as plus and minus 1 standard deviation of the average. It is a familiar ready-reckoner that can work for prices adjusted for inflation – or, in the case of securities, using ratings such as dividend yields or price/earnings ratios. Obviously, the implication is that when the price drops below minus 1 standard deviation then the asset is cheap; when the price is clear of plus 1 standard deviation then it is expensive. Almost equally obvious, the measure is flawed since the average and the outliers must always be changing as current prices change.

That said, it can be useful, and it says that currently gold is stinking expensive. Even that may not rule out a purchase. After all, if the purpose of holding gold is to provide risk reduction in a portfolio over the long haul, then it does not matter when it is added; it should perform that function all the same.

bearbull@ft.com