The Golden Dilemma

Although gold has been around for thousands of years, its role in diversified portfolios is not well understood. The authors critically examined such popular stories as “gold is an inflation hedge.” Investors face the following dilemma: The real price of gold is historically very high and may revert to the mean, but if prominent emerging markets increase their gold holdings, the real price of gold may rise even further from today’s elevated levels.Gold is an important asset, with a market capitalization of $9 trillion—roughly 10% of the combined capitalization of world stock and bond markets. Yet, gold’s role in diversified portfolios is not well understood.Our goal was to better understand the role of gold in asset allocation. We started by critically examining many stories about gold: Gold is an inflation hedge, a currency hedge, an attractive asset when there are low real returns, a safe haven, desirable because we are returning to a de facto world gold standard, and underrepresented in most investors’ portfolios. We show that gold may be a good inflation hedge over many centuries but a poor inflation hedge for horizons up to 20 years (the relevant horizon for most investors). We argue that gold is also an unreliable currency hedge. Even in periods of hyperinflation, gold may not keep its real value. We also argue that gold should not be counted on as a safe haven in times of extreme stress, such as war.There are widely divergent views on the value of gold, even among expert investors. For example, Warren Buffett believes gold is overvalued and compares the current value of gold to three famous bubbles: the tulip bubble, the dot-com bubble, and the recent housing bust. In contrast, Ray Dalio argues that there will be an ugly contest to depreciate the three main currencies by printing money and investors own a dangerously small amount of gold.Our analysis examines the price of gold over the past 2,000 years, but most of our analysis focuses on the post-1974 period, when it was legal to own gold in the United States. Over the recent period or even over the extended historical period, the current real price of gold is high. In the past, when the real price of gold was high, subsequent returns were low, reflecting a mean reversion, and the mean is $780 over the recent period.There is, however, a plausible scenario for the other side of the argument. What if the BRIC countries increase their gold holdings to a level that reflects the U.S. gold/GDP ratio? Our analysis shows that the BRIC gold holdings would have to triple, leading to an accumulation of an extra 4,000 metric tons in reserves. The entire annual world production of gold is less than 3,000 metric tons. Even the most aggressive buyer of gold, China, has managed to increase its holdings by only about 50 metric tons a year over the past 11 years. The demand for an extra 4,000 metric tons would likely lead to higher prices.In the end, investors are faced with a golden dilemma. Will history repeat itself and the real price of gold revert to its long-term mean? Or have we entered a new era with new emerging markets, where it is dangerous to extrapolate from history? Those are the uncertain outcomes that gold investors have to grapple with.Editor’s Note: A short piece called “Chinese CFOs Think China Should Triple Gold Holdings” and a Chinese translation of it are available as Supplemental Information at www.cfapubs.org/toc/faj/2013/69/4.Authors’ Note: Campbell R. Harvey is associated with the Man Group, plc, as its investment strategy adviser. Some of the Man Group’s investment funds trade gold as part of diversified commodity portfolios. Professor Harvey does not offer to the Man Group any advice on gold investment, and the Man Group was not involved in providing financial or other support for this independent research. Claude B. Erb is unaffiliated and also has no conflict of interest.