This post explores whether gold can act as a hedge for your investment portfolio during uncertain times. You will learn why gold has value, what purpose it serves for investors, and the different ways you can purchase it. We'll also provide several charts that compare gold's performance to the S&P 500 Index during market downturns, to evaluate how well gold works as a protective asset.
The Purpose of Gold in a Portfolio
Gold is a store of value.
Up until 1933, gold was used as the "gold standard," where the value of paper money issued by the Federal Reserve System (aka the Fed, the central bank in the U.S.) was directly tied to the value of gold. Even though the gold standard was officially abandoned in 1971 by President Richard Nixon, gold is still treated as an important financial asset while not being classified as a true commodity, security, or currency.
Fiat currencies like the U.S. dollar lose value over time from inflation and from the near-infinite quantity that can be printed by the Federal Reserve. However, gold is a finite resource that cannot be infinitely added to the economy. Its price is therefore not influenced by the solvency of any institution.
Moreover, gold prices are also generally inversely correlated to the strength of the U.S. dollar. The chart below compares one of the U.S. dollar indexes to the price of gold:
Gold is also often mistakenly considered a commodity, which by definition is "a generic, largely unprocessed, good that can be processed and resold."
However, gold is not a commodity, primarily because commodities have some industrial output used widely in the economy (i.e., oil, corn, copper). Gold is used much less in the industry and behaves more like a monetary asset. So, if anything, it can be classified as "commodity money."
Investors invest in gold because it's considered as a "safe haven" when there's any perceived fear in the stock market declining. Again, this is because gold is a defensive-play asset and a store of value with a fixed quantity. Therefore, investors flock to gold because of its "recession-proof" feature and because it isn't directly correlated to the stock market.
Gold is therefore bought by investors to hedge against inflation and economic turmoil, thereby further diversifying one's investment portfolio. This can improve the risk-return trade-off of an investment portfolio, potentially providing investors more return with less risk exposure.
Below is a chart showing the price of gold from 1950-2020 and recessions during the period:
Gold prices and its performance over recessions will be examined further in the following section.
Related: A History of Gold Returns
Analyzing Gold as a Hedge
Below is a historical price performance comparison of S&P 500 Index and gold prices:
Unfortunately, this comparison alone doesn't tell you much on whether gold is a strategic hedge for your portfolio. The sections below therefore examine gold prices in comparison to the market over the three most recent recessions.
Correlation
Correlation is the interdependence of variables that ranges from -1 to +1. A perfect positive +1 correlation means that the two assets move together. A perfect -1 correlation means that as one asset goes up, the other always goes down.
Below is a list of correlation ranges and its respective level of correlation:
- +/- 0.9 - 1.0: Very strong correlation
- +/- 0.7 - 0.9: Strong
- +/- 0.5 - 0.7: Moderate
- +/- 0.3 - 0.5: Low/Weak
- +/- 0 - 0.3: Negligible correlation
When it comes to gold and determining whether it's a good hedge for one's investment portfolio, we should expect to see correlation close to zero or in the negative range. The more negative the correlation, the better of a hedge the asset (gold) is. Another aspect to examine is whether gold prices appreciated more than the stock market during this downturn period.
For the following examples, keep in mind that correlation can vary depending on the time frame selected and that past performance is not an indicator of future results.
Moreover, we'll compare gold prices and the S&P 500 by showing the percent change from the beginning of each selected time period. This method only shows how prices changed during the specific period we're examining, not any price movements that happened prior.
Dotcom Recession
Although the recession following the Dotcom Bubble only lasted 8 months (from March 2001 to November 2001, highlighted in the chart below), the market's decline was much longer. The chart shows the market's journey from its high point around March 2000 to its low point in October 2002, after which it finally began to recover:
As the chart illustrates, the S&P 500 and gold prices generally acted in an inverse manner, as you would expect the two to react when the market is pulling back and more investors are buying gold. In this case, buying gold would've likely helped to offset your stock market investment losses.
The correlations between the S&P 500 and gold prices for these two periods are below:
- 03/01/2000 - 10/31/2002: -0.12
- 03/01/2001 - 11/01/2001: 0.09
From these two periods, the S&P 500 and gold prices have a negligible correlation and are slightly inversely correlated.
Great Recession
The Great Recession lasted from December 2007 to June 2009. In the chart below, the highlighted area from May 2008 to March 2009 shows when the market experienced its most severe losses before finally beginning to recover:
As you can see, gold prices were rather volatile during these periods, but it did end both periods higher. The S&P 500, on the other hand, was down 54% at its lowest point. Therefore, if gold was in your portfolio as a hedge during the Great Recession, it would've helped offset stock market losses.
The correlations between the S&P 500 and gold prices for these two periods are below:
- 12/03/2007 - 06/29/2009: 0.05
- 05/01/2008 - 02/27/2009: 0.25
From these two periods, the S&P 500 and gold prices have a negligible correlation.
COVID-19 Recession
The COVID-19 recession officially lasted from late February 2020 to April 2020. In the chart below, the highlighted area from late February 2020 to June 2020 shows a period of extreme market volatility and widespread uncertainty. This would have been the ideal time for investors to purchase gold if they hadn't already done so:
This market downturn was rather short and quickly recovered. It's interesting to see how gold prices were down 9% the same day when the market was down 32% (on March 20th). However, there's a much higher correlation here overall, which may have been due to a mixture of lowering interest rates and uncertainty causing people to still buy gold, among other reasons.
The correlations between the S&P 500 and gold prices for these two periods are below:
- 02/20/2020 - 01/29/2021: 0.75
- 02/20/2020 - 05/29/2020: 0.55
From this data, the S&P 500 and gold prices have a moderate to strong correlation.
Hypothetical Scenario Analysis
Based on the scenarios above, gold appears to provide hedge benefits for a stock portfolio during market downturns. The three market corrections we examined support this conclusion.
Let's now look at a hypothetical analysis where we invest $10,000 at the beginning of each of the six periods discussed earlier.
Instead of putting everything in the S&P 500, we'll place either 5% ($500) or 10% ($1000) in gold. This matches the allocation percentages many financial advisors recommend. We'll compare these results to a portfolio invested only in the S&P 500:
The results show that adding 5% or 10% gold to an investment portfolio before these market crashes generally reduced losses, especially during the Great Recession.
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Download ChecklistRemember that this analysis doesn't account for compounding effects and assumes you only invest in the S&P 500 and gold, not other assets like bonds. Still, based on these six market pullback examples, gold (particularly at a 10% allocation) appears to be an effective hedge during economic downturns.
Where to Buy Gold
In this section, we'll discuss the various ways you can go about buying gold, and which we would recommend buying as a hedge. These are all ways of gaining direct exposure to gold prices.
Physical Gold
To begin, you can purchase physical gold itself, meaning gold bullion in its bar, ingot, or coin form.
Several institutions (e.g., APMEX or JM Bullion) sell gold in this standardized form. This may be a viable option if you want to be hedged and avoid management fees and related risks. However, this is not a very viable or attractive option for most investors as it needs to be stored and may also be less liquid and more difficult/costly to sell.
Gold Mutual Funds or ETFs
The average investor gains exposure to gold from gold mutual funds or gold exchange traded funds (ETFs). These funds represent securities that are directly tied to the value of a specific gold deposit.
Here are two common gold ETFs and their respective expense ratios:
Although these funds require management fees, buying gold funds traded in the stock market offers high liquidity and relatively low-cost gold exposure. This is especially important when there's high market fear and/or when the market is crashing.
Gold Miners
Another approach to gain exposure to gold is to buy the stock of gold producers, meaning the gold mining and processing companies that actually produce the precious metal itself. In general, the stock price of these companies tend to follow gold prices, but can deviate from the added risks of investing in an individual company, both in a positive and negative direction.
For instance, a gold miner that is heavily levered will follow the price performance of gold until its debt is too much, eventually leading to a plummeting stock price. On the other hand, a well-run gold mining company, led by a competent management team, may continue to grow earnings and outperform other gold mining competitors, even as gold prices fall.
Most investors that want to own gold as a hedge should avoid investing in gold miners, and just stick to gold ETFs. Many gold miners are highly levered, which alone is a big risk. Moreover, if you buy a gold miner, you should invest in one that has more upside if gold prices go up, which requires a deeper dive into the company that may or may not payoff.
Gold Futures
You can also gain exposure to gold through derivatives, specifically futures. You can buy futures contracts and use leverage to purchase gold and gain exposure to gold prices over a specific period of time without actually needing to handle the metal itself.
Although this will add more risk (and potential return) to an investment portfolio, sophisticated investors can use this strategy to hedge their portfolio without having to worry about a management team or fund fees.
The Bottom Line
Gold is a store of value and is generally a good hedge against inflation and economic turmoil. Although gold prices are largely speculative, gold is fixed in quantity and many investors retreat to gold when market fears are high, which can help reduce their portfolio's downside risk.
When gold prices fall, this often means the stock market is performing well. Since gold serves as a hedge and should only make up ~5-10% of your investment portfolio, these price movements show the diversification is working as intended.
Adding gold exposure to your portfolio is straightforward (such as buying a gold ETF), and this diversification strategy is a smart long-term approach to investing.
