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The Value of Investing in Gold as a Hedge

Fajasy
Updated: February 26, 2021
Reading Time: 9 minutes

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In this article, I will discuss the value of investing in gold as a hedge for your investment portfolio. In the process, I will cover why and how gold carries value, the purpose gold serves in an investment portfolio, and the different ways investors can buy gold. In addition, multiple charts and comparisons to the S&P 500 during market downturns will be provided to better understand how effective gold is as a hedge and whether it's worth buying at all. Ultimately, this should help investors make smarter investment decisions, especially when a market downturn may be on the horizon.

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 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 overtime from inflation and from the 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 (DXY) to the gold futures price (GC=F):

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 at less risk.

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 looked at closer in the next section. You can see a breakdown of gold performance over different time frames HERE.

Analyzing Gold as a Hedge

Below is a historical price performance comparison of the S&P 500 Index (using the SPY ETF) and the gold futures price (GC=F):

Unfortunately, this comparison alone doesn't tell you much on whether gold is a good hedge for your portfolio. Therefore, I decided to examine gold prices in comparison to the market over the three most recent recessions. Although charts will be shown, you can also opt into adjusting the sliders in the chart above to the appropriate market recessions discussed shortly if you want a closer look.

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 measures close to zero or in the negative range. The more negative the correlation, the better of a hedge the asset (gold) is. Another thing to look at 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, I will be comparing the performance of the S&P 500 and gold prices since the start of the selected period by percent change, which ignores any price movement prior to the select period.

Dotcom Recession

Although the Dotcom recession only lasted 8 months, from March 2001 to November 2001 (highlighted area), the chart below shows the market high (roughly) from March 2000 to the low in October 2002 before the market began to recover again.

As the chart shows, 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 absolutely 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.

The Great Recession

The Great Recession lasted from December 2007 to June 2009. The highlighted area from May 2008 to March 2009 represents a period of significant losses until the market began to recover.

As you can see, gold prices were rather volatile during these periods, but it did end both periods higher unlike the S&P 500 which 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 began in late February 2020 and has still yet to technically end. The highlighted area (in the chart below) from late February 2020 to June 2020 represents high market volatility, and is generally when there was a lot of uncertainty in the market. Ideally, this is when investors were buying gold if they had not already.

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.

Again, 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, although the recession is not over yet.

Hypothetical Scenario Analysis

For the scenarios above, we saw various market conditions and how gold prices reacted to market downturns. Overall, it's fair to say that gold would provide hedge benefits to a stock portfolio, at least according to these three market corrections.

Now, I will perform a hypothetical scenario analysis where I would've invested $10,000 at the beginning of each of the six periods discussed before, but 5% ($500) or 10% ($1000) of my portfolio would be in gold instead of just the S&P 500. This percentage allocation to gold is generally the rule of thumb that many investors follow. I will compare this to exclusively owning the S&P 500 as well.

As you can see, a 5% or 10% allocation to gold in an investment portfolio prior to these stock market crashes would've generally worked well as a hedge to offset losses, particularly in the Great Recession. However, keep in mind that this hypothetical ignores compounding and assumes you only invest in the S&P 500, and not anything else such as bonds. Regardless, from these six market pullback examples, it appears that gold is a worthwhile hedge to invest in during times of economic trouble.

Where to Buy Gold

In this section, I will discuss the various ways you can go about buying gold, and which I would recommend buying as a hedge. These are all ways of gaining direct exposure to gold prices, where you can hopefully buy low and sell at a higher price.

Physical Gold

To begin, you can buy physical gold itself, meaning gold bullion in its bar, ingot, or coin form. Several institutions (i.e. APMEX or JM Bullion) sell gold in this standardized form. This may be a good 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. 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.

Here are two gold ETFs I can recommend as a gold hedge and their respective expense ratios:

  • iShares Gold Trust (IAU): 0.25% expense ratio
  • SPDR Gold Shares (GLD): 0.40% expense ratio

Gold Miners

Another approach to gain exposure to gold is to buy the stock of gold producers, as in 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. The same could be said for an incompetent management team. On the other hand, a well-run gold mining company may continue to grow earnings and outperform other gold mining competitors, even as gold prices fall.

In general, I'd say 95% of 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 are to 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 return to an investment portfolio, experienced investors can use this strategy to hedge their portfolio without having to worry about a management team or fund fees.

The Bottom Line

In summary, 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 relatively fixed in quantity and many investors retreat to gold when market fears are high, which can help to limit their portfolios downside risk.

Because gold is a hedge, which should only take up 5% or 10% of your investment portfolio, you should actually be happy when it's losing value, as this likely means that the rest of your portfolio is doing well. Ultimately, it's rather simple to gain exposure to gold (i.e. buying a gold ETF), and owning gold to further diversify and hedge one's investment portfolio is a smart long-term approach to investing.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance investment or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.
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