All That Glitters
There are few investable assets so viscerally exciting as gold. This funny yellow element has stirred passions from time immemorial. In addition to exciting, it’s also controversial. In investment circles gold tends to be almost as polarizing as ‘the Donald’.
Gold enthusiasts (aka gold bugs) are often lampooned as tinfoil hat wearing weirdos. Picture a militiaman deep in the hills of Montana, stockpiling canned beans, and ammunition. Of course the antipathy runs both ways. Gold bugs cast their detractors as hopelessly naive to the risk of the money printing press, but also more generally to the fragility of civilization at large.
Of course, gold bugs aren’t all crazy. Hyper-inflation is not a purely theoretical risk. Just ask anyone from Venezuela. And wars - closely associated with spells of inflation, destruction of capital and poor returns for bonds and stocks - are never so far off as imagined. When should you want to own a ‘safe haven asset’ if not in extreme scenarios like those? There is something comforting in the notion of allocating a portion of your client’s wealth into something that will, in all probability, never be destroyed, made obsolete, or be debased by a central bank.
On the other hand, it’s a mistake to run one’s life or portfolio focused overwhelmingly on worst case scenarios; or as strategists like to call them - “tail risks”. Economic collapse doesn’t happen every day and it’s difficult to grow wealth when you spend all day in a metaphorical bunker. Gold produces no cash flows for its owners, has limited real world use (at least at prevailing prices) and in that sense, produces no real value over time, unlike stocks and bonds. In a sense, it’s dead money.
Is there any kind of middle path between these two ideological poles? Dead money versus ultimate safe haven? We think so.
Gold is not truly a productive asset. Like other commodities, the long-run rate of return is expected to be well below that of stocks, albeit with similar or higher levels of volatility. At NextStep, we believe that over the very long run, gold will tend to be a drag on most portfolios. Yet, gold has something very few assets possess: the potential to perform positively in both extreme inflationary and extreme deflationary scenarios. These are both scenarios when a traditional 60/40 portfolio will take a pounding. Portfolio nerds sometimes refer to this Janus-like quality of gold as ‘convexity’. Convexity is valuable stuff for a portfolio architect.
Let’s not exaggerate things. It would be wrong to think of gold as a kind of portfolio insurance. It’s far too unreliable a performer for that role. It provided little shelter for investors in 2008 and failed to catch a bid in 2021, even as inflation surpassed 7% and real rates went deeply negative. Like an unruly teenager, it sometimes seems that gold has its own priorities beyond the role we assign for it. It can be driven by technically-minded traders without regard for anything you might call fundamentals. It can serve as a liquidity source for panic-stricken portfolio managers in times of market stress, even when it might otherwise be in a position to shine. A central bank may distort the market for months or years at a time with a secret buying or selling program.
Still, much as people’s greatest weaknesses can hint at their strengths, gold’s very unpredictability in less-than extreme market environments turns out to be something useful. Gold has a correlation to stocks (in USD) that averages around zero over the long term. Correlation that low is itself a precious commodity.
To summarize, gold is an asset that tends to go up modestly in value over time (at least in nominal terms), has genuine diversification value versus stocks and bonds, and has a good chance of outperforming in not one but two tail-risk (disaster-type) scenarios. We think that’s a pretty good reason for considering gold when building conservative, safety-first type portfolios.
In short, a lot of crazy people are gold lovers, but not all gold lovers are crazy.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.