All that glitters is not gold

At nearly US$2,000, the price of gold is at an all-time high, up more than 25% in 2020 and 50% since the beginning of 2019. In the current environment, this gold craze is not surprising. Many investors - encouraged by industry professionals - see gold as a hedge against inflation and a safe haven in times of instability. With central banks printing trillions of dollars, there is a risk that sooner or later there will be a surge in inflation. For the promoters of gold as an investment, the question is not whether or not to hold it, but rather how much of the portfolio to devote to it. The evolution of the gold price over the last two years seems to prove them right.

If you are tempted to follow their lead and rush to the local numismatist or buy from one of the online gold bullion sites, however, we suggest you consider the following.

Gold does not protect against inflation

One of the most persistent investment myths is that gold is a good hedge against inflation, i.e. that the price of gold would rise in times of high inflation. This myth - cleverly perpetuated by all the companies that trade in gold - probably has its roots in the 1970s, when the price of gold rose from US$35 in 1973 to US$843 in 1980, while inflation was taking its toll.

The main reason for this surge in gold prices is the abandonment of the goldstandard by the United States in the early 1970s. Until then, the dollar was convertible into gold at a rate of $35 per ounce. At the same time, the oil shock triggered a strong inflationary surge and led the US Federal Reserve to raise interest rates to over 20% in 1980.

From its peak of $843 in 1980 (chart 1), however, the price of gold fell by more than 50% to a low of $297 in 1982, while inflation continued to be rampant (more than 10% in 1980 and 1981 and 6% in 1982). The investor who bought gold at its peak in 1980 had to wait more than 25 years before recovering the value of his investment - not to mention the cost of holding that gold and the effect of inflation. Thus, after rising 22% per year after inflation from 1970 to 1980, gold fell 8.5% per year from 1980 to 1990 (chart 2). Anyone who would have bought gold during the financial crisis of 2008 did little better.

A study[1] published in 2013 estimates that, from 1836 to 2011, the average annual increase in the price of gold after inflation was 1.1% - roughly the same return as risk-free treasury bills - despite a high volatility of 13.1%. Worse still, the price of gold does not rise any more in times of crisis than in normal times.

Gold generates no income

Unlike a diversified portfolio of stocks that pay regular dividends (currently 3.3% annually on the S&P TSX Composite) or bonds that pay interest (1.2% on the FTSE Canada Universe Bond Index), gold generates no income. This difference is fundamental since dividend and interest payments account for more than half of the long-term return of a diversified portfolio. There is therefore a very high opportunity cost to owning gold.

A $100 investment in gold in 1978 would be worth $670 today (chart 3) while the same investment in a portfolio composed of 60% S&P500 and 40% US bonds would be worth $5,900, almost 10 times more.

More recently, some argue that since interest rates on government bonds are very low - just over 0.50% in the U.S. and Canada - the opportunity cost of holding gold is very low. This argument is fallacious because gold cannot play the same role as bonds in the portfolio; bonds offer protection against deflation, which is the other risk currently facing the world economy.

Gold is expensive to buy and hold

In addition to this opportunity cost, it is also expensive to buy and hold gold, whether you buy bullion directly or invest in a fund that holds gold.

The individual investor who buys bullion typically pays a premium of 3% to 5% over the gold price. This premium is used to compensate the intermediaries between the gold producers and the investor. The same applies to the sale, which is done at a 3% to 5% discount. The price of gold will have to increase by 6% to 10% before the investor starts making money.

In addition to transaction costs, there is a recurring cost associated with holding gold, which requires a safe deposit box at a bank or a safe deposit box at home. In either case, the problems of transportation and insurance arise. Home insurance generally does not cover gold theft (except for jewelry) and those that do are very expensive.

Buying gold indirectly through a fund or even futures contracts does not eliminate these problems. The fund must also bear the costs of trading and custody of the gold if it is physically held or the costs associated with rolling over its futures positions as they mature.

You already have gold in your portfolio

If you have a diversified portfolio of Canadian stocks, gold already makes up 10% of your investments through gold companies. These stocks have performed very well, up over 40% in 2019 and 32% in 2020.

Why does the gold myth persist?

Given all these flaws, why does gold retain its aura with many investors?

Long before the existence of central banks and government-issued fiat money, gold was used as a currency of exchange. In fact, as mentioned above, until the 1970s, the U.S. dollar was convertible to gold at a fixed price. Since this gold standard was abolished by President Nixon in 1971 and private ownership of gold was legalized by President Ford in 1974, many companies have been in the gold business (!) selling gold in all its forms to individuals. Unfortunately, the same cannot be said for individuals who have made mediocre returns. In fact, since many investors tend to buy gold when it has gone up a lot (like now) and sell when it goes down (to buy stocks!), they make a flat negative return, both before and after inflation.

All that glitters is not gold!

[1] Barro, Robert J. and Misra, Sanjay, Gold Returns (February 2013). NBER Working Paper No. w18759, Available at SSRN: https://ssrn.com/abstract=2210778