Summary 

• Gold can be used for portfolio diversification as well as protection against market events.
• It moves in the opposite direction of the market, so it may be used as a hedge against inflation.
• Not more than 10% of your overall portfolio should be invested in gold.

Gold has been valuable for over thousands of years and has been used as a medium of exchange before money was introduced. Even after its introduction, every country, before 1971, used to value its currency based on a fixed gold weight. For example, the US legally setting its gold price from 1834 to 1934 as US $20.67 per ounce. Paper bills could be exchanged for gold at the established rate, as gold was considered as money under the system of gold standard. After 1971, the gold prices were set free instead of being artificially fixed, and investors were allowed to buy gold post-1975.

Unlike other metals, gold is considered more valuable as it is relatively scarce, and therefore, is used as a status symbol. It is durable and acts as a long-term store of value, and it’s malleable too. Also, as it is difficult to acquire, it holds more value, unlike metals like aluminum which have lost value due to easier extraction. Gold is majorly used as jewellery and for investment purpose, but it is also used by central banks for hedging, and also by the technology industry, as it is an electrical conductor.

Also read: Top 5 AIM gold stocks for August 2021

Gold has many advantages, such as diversification of your portfolio, beating inflation, hedge against excessive central bank money-printing, and balancing losses from the stock market as it is uncorrelated to stocks and bonds. But it has many disadvantages as well, such as not hedging in times of short-term inflation, producing no cash or dividend like shares, having no intrinsic worth, and therefore, being useless in a real crises. Gold proponents generally argue that it acts as a hedge against the rising levels of inflation, and its uncorrelation to stocks and bonds helps in protecting your portfolio from an equity market crash. But does gold really act as a hedge against inflation as well as a stock market crash? And how much gold one should have in his investment portfolio?

Gold as an inflation hedge

Unlike shares which pay dividends, gold doesn’t generate any cash, and in turn it costs you money to keep it. Cash generation usually leads to compounding and higher returns, and thus, a lack of cashflow from gold makes it less likely to have a growth rate. As a hedge against long-term inflation, gold has been very strong and has maintained its purchasing power over centuries, even since the Babylonian and Roman times. But this is not useful for today’s gold investors, due to a limited investment time horizon which can’t be thousands of years, and because gold is altogether a different asset class today.

As a hedge against short -term inflation, UK investors would expect gold to keep up with the inflation. But as per the data, there is no correlation between gold (in sterling) and UK RPI. There would still be a slightly positive correlation between gold and inflation for the US investors, which would make gold a better inflation hedge for them in the short term as well, but it only happened for a few specific years where gold performed well against exceptionally high inflation. In case of UK, there is no such evidence of gold acting as an inflation hedge.

It is also usually expected that stocks would have higher maximum drawdowns as compared to gold, but that’s not true. Between 1980 and 2000, a gold investor would’ve suffered an 80% drawdown, as compared to a 56% drawdown in the equity market, as per Bloomberg data. Along with a greater magnitude, the gold drawdown also lasted for a longer period of 30 years. Although the recovery from the drawdown is accomplished, gold is proved not to be a good inflation hedge as it failed to keep up with the inflation for 20 years. Inflation-linked bonds may be used as an alternative to gold as a hedge against unexpected inflation.

Also read: A Year of Recovery: Top 10 Gold Stocks on LSE

Gold as cash protection

Gold acts as an excellent form of insurance during a market crash, as proved in the 2000 and 2008 crashes, where it gave positive returns in both. It provides protection even during smaller drawdowns, and it falls less than the market. Gold performs well as a crash insurance, even though it may not act as a perfect hedge. Even though gold is worse than stocks on all 3 metrics, which are risk, return, and drawdown, still gold somehow reduces the maximum drawdown risk and maximises the risk-adjusted returns from the portfolio.

Gold and Sterling

As gold is a free-floating currency, its value will rise as the Sterling falls, and its value will fall as the Sterling rises, in a Sterling-based portfolio. Depending on the proportion of your portfolio that is exposed to market fluctuations, the currency impact of gold on your portfolio will be determined. Gold is more likely to benefit your portfolio if it is sterling-heavy and comprises mostly of UK companies which derive their earnings domestically.

In this case, losses can be offset using the value of the gold position if the Sterling as well as the value of equity fall. But if you hold an equity portfolio of an unhedged position, and your index-tracker’s underlying securities are majorly non-sterling, then gold might not be as beneficial to offset the losses if the value of equity falls.

Summing up

Gold can be owned through gold ETFs, gold bars, and buying shares in gold miners. It can be used as a source of uncorrelated returns, and as a protection against inflation and crashes. Gold can be a good investment for diversifying your portfolio and balancing it to protect you from a market event. But it should not be more than 10% of your total investment portfolio, that too only for the sake of protection and diversification.