Tuesday, August 31, 2010

Gold by the Numbers

"Captain and kings
In the ships hold
They came to collect
Silver and gold
Silver and gold"
- Silver and Gold, U2

Lots of people have lots of opinions about the value of gold as an investment.  Most of the arguments either for or against are based upon a lot of platitudes like "gold is a hedge against inflation" or "gold just isn't all that useful except for making pretty jewelry".  Rather than rehashing the same well-worn arguments, I want to look at gold purely from a numbers standpoint.

Before I continue, let me just throw out a little disclaimer here.  My analysis is based upon looking at past performance numbers.  There is no guarantee that gold prices will continue to behave as that have all along.  Therefore, I will leave it to the intelligent reader to decide how they want to apply the numbers.

First, let's look at the historical returns of gold compared to the S&P 500 stock index over the past 35 years:

Avg Annual Return GoldAvg Annual Return S&P 500
Annual Return - Average8.33%9.24%
Annual Return - Std Deviation29.42%16.82%
Annual Return - Min-33.89%-40.09%
Annual Return - Max146.69%35.20%

As you can see, the average annual investment returns from gold are about 1% less than that of the S&P 500.  However, notice the volatility of gold compared to the stock market.  The standard deviation of gold, which is a measure of volatility, is almost double that of the S&P 500.  If you thought the stock market was a roller coaster, then the gold market is like riding a roller coaster in the middle of a tornado! 

Also look at the maximum return for gold.  There was one year (1979) where gold increased in price by a whopping 146.69%.  If you held gold that year, you would have more than doubled your investment.  That one year has a huge effect on the annual return of gold.  Let's see what happens when we remove it from the mix, by looking at the historical return from 1980 onward:

Avg Annual Return GoldAvg Annual Return S&P 500
Annual Return - Average3.65%9.25%
Annual Return - Std Deviation16.37%17.19%
Annual Return - Min-33.89%-40.09%
Annual Return - Max32.36%35.20%

Removing that year seems to have calmed things down a bit in terms of the volatility of gold.  However, the average annual return has dropped to 3.65%.  That means if you happened to start buying gold after that amazing year of 1979, you would have ended up doing far worse than you would have by investing in the stock market.

All these figures might lead one to believe that you are better off investing in stocks rather than gold.  Is that true?  Maybe.  Maybe not.

One hypothesis is that gold and stocks are negatively correlated.  This means that their prices tend to move in different directions, meaning that when the price of one goes up, the price of the other goes down, and vice versa.  If this is the case, then buying a little of both might be a good thing, since you are guaranteed that at least one of the two is going to go up.  In fact, during the recent economic crisis in 2008, this was the case.  The stock market dropped a whopping 40% while gold returned a modest but positive 3.28%.  Likewise, in 1997 during the height of the late 90's bull market, stocks were up almost 25% while gold was down 20%.  However, this relationship doesn't always hold.  There are years when they are both up and years when they are both down.

Let's look at the numbers if we had invested in some combination of stocks and gold over the past 35 years:

All GoldAll S&P 50010% Gold20% Gold30% Gold40% Gold50% Gold60% Gold70% Gold80% Gold90% Gold
Annual Return - Average8.33%9.24%9.15%9.06%8.97%8.88%8.79%8.70%8.61%8.52%8.43%
Annual Return - Std Deviation29.42%16.82%15.43%14.70%14.73%15.52%16.96%18.90%21.21%23.78%26.53%
Annual Return - Min-33.89%-40.09%-35.75%-31.42%-27.08%-22.74%-20.48%-23.16%-25.84%-28.53%-31.21%
Annual Return - Max146.69%35.20%32.03%40.73%53.98%67.22%80.47%93.71%106.96%120.20%133.45%

As you can see, adding some gold to a stock portfolio does reduce the standard deviation of the portfolio slightly.  The 20% gold portfolio has the least standard deviation which means it would have been the least risky, historically speaking.  However, as your gold exposure grows to 30% or more, the volatility would have increased and eventually it would have become more volatile than just holding an all stock portfolio.

On the other hand, you would have gotten slightly worse performance by adding gold.  Note that the 20% portfolio's average annual return drops about 0.18%.  Of course, it isn't a big drop.

Overall, the case for gold based upon the numbers isn't very strong.  Obviously holding all of your assets in gold is very risky.  However, holding a portion of your assets in gold might reduce your portfolio's volatility slightly at the cost of reducing your returns slightly.  As I stated at the beginning, this analysis is based upon past performance, so who knows if this trend will continue.  As a general rule, though, diversification among multiple types of investments is usually a good thing, so maybe a little bit of gold is something to consider.  If nothing else, owning gold will make you feel like a royalty but without the peasants getting stuck under your feet!

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