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There are a lot of misconceptions among today’s investors about Gold as an asset class. Many investors feel that Gold is an old-fashioned investment. And some investors are reluctant to invest in Gold because Gold doesn’t provide dividends or capital gains the way stocks can. But in these arguments, these investors don’t recognise that Gold, as a protective asset class, plays a crucial role in any balanced portfolio.
In a globally-diversified portfolio, a declining US Dollar will eat into your returns, but having an allocation to Gold hedges your investments against a depreciating US Dollar.
The value of the US Dollar can decline significantly if there’s an oversupply of US Dollars in the global economy. An oversupply of US Dollars drives international investors and major central banks to reduce their US Dollar exposure in order to preserve their assets’ value in their home currencies. Specifically, they reduce their US Dollar exposure by selling their US Dollar reserves and then buying Gold.
This act of mass offloading the US Dollar drives down its value while driving up the demand for Gold. Basic rules of supply and demand tell us that when demand increases, so does the price. We saw this exact scenario play out after the 2008 Financial Crisis: The Fed’s quantitative easing caused the US Dollar to depreciate by more than 20% on a trade-weighted basis by 2011. At the same time, Gold prices nearly doubled up until 2012.
A factor that makes an asset class a good diversifier is when its value isn’t correlated to other assets classes in a portfolio all the time. Correlation measures how one asset class moves in relation to another asset class. Two asset classes are positively correlated when they move in tandem, and negatively correlated when they move in opposite directions.
In the case of Gold, its prices are relatively uncorrelated to equities in good times and positively correlated to equities when the stock market is doing exceptionally well.
Figure 1 shows how Gold performs depending on how big of a move up or down the S&P 500 makes. When we see the S&P 500 move up or down moderately (less than 2 standard deviations), the price of Gold has very little correlation with the market. But, when the S&P 500 does exceptionally well as measured by an upward move of more than 2 standard deviations), Gold prices tend to move up along with the market.
To get to the heart of why Gold is such an important protection in a financial crisis, pay attention to how Gold performs when the market goes down significantly (down more than 2 standard deviations). As seen in Figure 1, Gold prices have a high negative correlation when the markets go down significantly. That is to say, when the market crashes, Gold goes up substantially.
During a financial crisis, Gold also tends to outperform asset classes, such as corporate bonds and real estate. For instance, the subprime mortgage crisis in 2008 drove a lot of real estate prices down and the fallout from the crisis caused corporate bond yields to go up as investors fled to safe-haven assets, such as, you guessed it, Gold.
So, a balanced stock and bond portfolio should also have an allocation to Gold to minimise your portfolio’s downside risk in a financial crisis.
Gold prices typically go up when geopolitical tensions escalate. People tend to accumulate physical gold in times of political crises because Gold is universally accepted as an asset with a reliable store of value that knows no region or currency.
Since the US-China trade war and Brexit, large institutions, such as hedge funds and central banks, are also stocking up on Gold as a way to secure themselves against major shifts in the global political landscape. The People’s Bank of China, for instance, added more than 100 tonnes of Gold in 2019 amid the trade war. While political noise causes volatility in the markets, these uncertainties only drive up the demand for Gold. Consequently, a portfolio protected with Gold experiences lesser volatility than a portfolio without Gold.
While Gold doesn’t pay investors returns in itself, Gold functions as one risk management tool that protects your investments against extreme events ahead of time. Political and economic uncertainty, financial crises, and a large decline in the US Dollar don’t happen often. But when these extreme events do happen, they can cause large short-term losses in a portfolio that isn't properly prepared with the right risk management tools, such as Gold. Ultimately, a strategic allocation to Gold will allow your portfolios to remain resilient even in the most unfavourable market conditions.