Gold is a popular investment. Yet, we don't consider it as good as is commonly believed. Its main problem is that it's an unproductive asset. The consequence is that the long-term expected return of gold is a lot lower than for instance stocks. We look at this in more detail, as well as other reasons why gold may not be that great. However, there are cases where an investment in gold does make sense, and we cover these.
Why gold isn't a good investment
It doesn't produce any value
The main problem of gold is that it does not produce value. If you invest in a stock, you get a dividend on top of the price. A bond generates interest. But a kilo of gold will still be a kilo of gold in 10 years' time and will not generate anything for those 10 years, except via possible price appreciation. On the contrary, it costs money to keep gold safe. Even if you invest in gold through an ETF, you will pay for holding the assets safe one way or another.
Warren Buffett also calls gold an "unproductive" investment, including in his 2011 letter to Berkshire Hathaway shareholders. "Unproductive investments will never produce anything, but people buy them in the hope that someone else, who also knows that these investments will be forever unproductive, will be willing to pay more for them in the future."
To make his point about gold clear, Buffett then imagines that he owns all the world's gold - at that time 170,000 metric tonnes - melted down into a cube of about 20 cubic metres. That mega-cube of gold would then be worth about $9.6 billion. With that money, Buffett notes, you could also buy all 400 million hectares of arable land in the US, as well as sixteen times the entire company Exxon Mobil, at that time the most profitable company in the world with a generous dividend. To then be left with a billion dollars.
So what would you rather own for the long term? Buffett himself does not have to think about it for long: "A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond."
Low expected returns
Because it's an unproductive asset, in the long run, gold yields a return barely above inflation. For instance, since 1900, gold delivered an average annual real return of just 0.8% (net of inflation, that is). During the same period, stocks returned an average 6.9% per year!
We've been seeing a similar trend in recent history. Between 1980 and today, the global stock index MSCI World returned an average 10.3% per year, whereas gold returned only 5.9% per year.
Volatile
Gold not just has lower expected returns than a productive investment like stocks, it is also more volatile. This means that the value of gold fluctuates significantly. Good investments compensate you for taking on additional risk through a higher return. That's not the case for gold. You get high volatility, yet also a low return.
When investing in gold makes sense
Given these drawbacks of gold, why would anyone invest in it? There are a few use cases.
Insurance against doom scenarios
What if the whole financial world collapses? A number of risks cannot be denied. Governments are borrowing far too much, and a situation threatens where they can never repay their debts. Could this lead to substantial monetary devaluation? And what about geopolitical problems such as wars? These too could throw a spanner in the works of many investments. Globalisation could then evolve back into protectionism, which could put companies in trouble. In short, things often don't look good in the world. So what can you insure against such a difficult, certainly not unrealistic situation?
In the past, many then chose gold and other precious metals time and again, as an escape value. The Romans were already attracted to the yellow, heavy metal. As the ultimate, portable wealth that was separate from governments with their paper money. Just ask the Germans during the period between 1921 and 1923, the Argentines in the 1990s and, more recently, Turkish and Russian savers. Each time, physical gold is the exchange value that everyone will accept. Historically, everyone has always agreed that the yellow metal equals value. Gold protects purchasing power, in the longer term.
Diversification in your portfolio
The value of gold moves fairly independently from the stock and bond market. In finance parlance, we say that gold has a low correlation with stocks and bonds. This means that having gold as part of your portfolio offers a diversification benefit, which can help taming the fluctuations of a portfolio.
The chart below shows the correlation between gold and the MSCI World index. There are periods where the correlation is fairly high, but also many periods where the correlation is close to -1.
Insurance against a calamity in the financial markets is useful. After all, in a truly severe disaster, the price of gold would multiply. The only question is whether this should dominate your portfolio? You don't pay as much for your fire insurance as you do for your entire house, do you? Therefore, you better not invest more than 3% of your assets or 5% to 10% of your investment portfolio in gold. If you invest a higher percentage, you are actually aiming for such a huge disaster. However, what are the chances of such a major financial disaster occurring? It has not occurred in the last 100 years.
Hedge against inflation
Gold is typically seen as a hedge against inflation. Inflation causes prices to go up, and the idea is that the price of gold more or less follows inflation, preserving your purchasing power. However, research indicates that it may not be as effective as an inflation hedge as commonly believed.
Questions you may have
What are the disadvantages of gold?
The most important disadvantage is that gold does not produce any value. A stock pays out a dividend every year, and a bond pays out an interest. But a kilo of gold today will still be a kilo of gold in 10 years, and won't give you anything but storage costs. Because of this, the expected return of gold is very low. The price of gold is also very volatile.
How much return does gold have per year?
Since 1900, gold has delivered an average 0.8% return per year, after inflation. As a comparison, the stock market has returned 6.9% per year during the same period.
What is the best way to invest in gold?
Physically-backed gold ETFs are the most convenient way to invest in gold. Vaults in London hold numbered and controlled gold bars that are used as the basis for the physical gold ETFs that you buy on an exchange.
But the true doomsayer will want to buy physical gold bars. Depending on the disaster you anticipate, soon there may not even be a functioning stock exchange where you can sell gold ETFs, or you may not be able to find, let alone open, the vault where the ETF keeps your gold bars. On the flip side, you'll have to find safe storage. You better not put those gold bars under your mattress!