"Gold is a hedge against inflation." Meaning?

Factual Questions
81

Ok, let drill down and consider the consensus among economic theorists regarding gold. I’ll pull some textbooks off my bookshelf. John Cochrane, Asset Pricing 2001: no entry in the index under either “Gold” or “Precious metals”. Bodie, Kane, Marcus (BKM) Investments 1999, ditto. BKM does have references to commodities, though not “Metals”. They discuss futures contracts.

Gold is considered a sideshow, not worth spending too much time on. Portfolio manager David Swensen in Unconventional Success 2005 contrasts core asset classes with non-core asset classes. Gold doesn’t make either list, nor is it listed in the index.

Sharpe et al Investments have an entry on gold in their index. It is listed under Tangible Assets in Appendix A.2 of their last chapter; discussion is less than half a page. They mention that gold isn’t correlated with the stock market, assert that it’s correlated with the CPI (not so sure about this: my linked 2009 paper suggests otherwise), and mention that there are many methods of investing in gold and that silver and other precious metals have similar properties for those interested. Not a rousing endorsement, more like an afterthought.

82

well, I mean, Harry Browne, for one. Hence my reference to the permanent portfolio. And modifications thereto such as the “golden butterfly” and Ray Dalio’s “all weather” portfolios. Let me be clear, I don’t invest in gold, for many reasons. Sounds like you are of the same mind. But it’s not unreasonable to consider it as one (minor) part of a well thought out allocation.

83

The old 60/40 portfolio advice. Not a criticism of you but:

60/40’s Oddball Origin Story

We don’t need to dive too deep into the economic weeds here, but the origin of the 60/40 rule is an interesting tale, so let’s take a side trip into it for a moment.

The rule emerged in the 1950s, as a group of advisors tried to integrate the Nobel Prize–winning research of Harry Markowitz, who founded Modern Portfolio Theory (MPT), an important concept in diversification.

Advocates of 60/40 like to say it’s part of MPT, but it isn’t. Markowitz himself began with a 50/50 allocation for his own assets, which, he said, he did “to minimize my future regret.”

He also did it without doing an actual analysis of the data: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it.”

So the 60/40 rule comes from a misunderstanding of a bias that inspired a Nobel Prize–winning economist to build a theory. It isn’t the conclusion of the theory he developed!

Going from 2006 to current - an investor who put in $10,000 per year has missed out on about $700,000 following the 60/40 plan versus the NASDAQ 100 (QQQ ETF) over this time period, and about $300k over the S&P 500 (SPY ETF).

84

@We_re_wolves_not_werewolves : Neither of the 2 people you cited are economic theorists. But they do give us something to discuss.

Wiki:

Harry Edson Browne[1] (June 17, 1933 – March 1, 2006) was an American writer, politician, and investment advisor. He was the Libertarian Party’s presidential nominee in the U.S. elections of 1996 and 2000. … Browne was an investment advisor for much of his life and developed the so-called “permanent portfolio” investment strategy, which claims to identify the four types of economic conditions that can apply over a given investment period, and the appropriate asset classes that give both profit from the upside of these conditions, and some measure of protection when they cease to prevail. Browne published his first book, How You Can Profit From The Coming Devaluation, in 1970.

Browne was an investment writer. The Permanent Portfolio (1999) had mixed reviews. It did recommend 25% be put in gold and other precious metals as a way of protecting against inflation according to wikipedia. I opine that inflation protected bonds, first offered in the US around 1997, are a far superior hedge.

Ray Dalio is a hedge fund manager. He once purchased a large amount of gold, which performed well. I’m not clear on whether he sees gold as a good permanent investment. Wiki says, " His strategy mainly focuses on currency and fixed income markets.[25] This is in contrast to buying individual shares in companies, like investors such as Warren Buffett and Peter Lynch." Following the paper cited above, I opine that gold is a reasonable alternative to other foreign currencies, though it pays no interest. Wiki:

In 2008, a disastrous year for many of Bridgewater’s rivals, the firm’s flagship Pure Alpha fund rose in value by 9.5% after accounting for fees.[9] Dalio did this by anticipating that the Federal Reserve would be forced to print a lot of money to revive the economy. He went long on Treasury bonds, shorted the dollar, and bought gold and other commodities.[9] … The next year was not as bright. In 2009, when economic growth was higher than expected and the Dow Jones Industrial Average increased by 19%, the company’s Pure Alpha fund reportedly earned just 2% to 4%.[29]

I’m curious about how Dalio allocated funds between commodities, gold and foreign currencies/bonds in 2008. Did he just short the dollar and leave it at that? What was his reasoning for this opportunistic trade, beyond anticipating looser monetary policy? Here’s one possibility: gold, which doesn’t pay interest, performs better during conditions of low inflation adjusted interest rates, which occurred during the 1970s and the financial crisis. I suspect that influenced Dalio’s reasoning.

ETA: I see that Dalio’s all weather portfolio consists of, “30% on the Stock Market, 55% on Fixed Income, 15% on Commodities.” That’s… interesting. Certainly not crazy. Fixed income gets creamed during inflation surprises but I guess it relies upon commodities taking off. Huh. Not exactly gold buggery, but I assume that it has some exposure to that precious metal. I see that an ETF based upon it was launched 3 days ago.

85

Again, though: Even if gold is uncorrelated to the equities/economy/Astrological Signs, so what? Uncorrelated 5% still sucks. And if your horizon is long, it ceases to matter if an asset is down when you sell it. I have an S&P 500 lot purchased May 16 2016 and as of this writing it’s up 184%. If the market goes into a big 25% correction I’m still way ahead of gold if I had to sell that lot.

(And I’d have made my point more bigger by going back farther but 2016 is when I moved everything to Fidelity, so that’s as far back as I can go)

86

I hope that most understand that a typical “balanced portfolio” will with great probability, over decades, lead to lower end returns than being all in on the equity side. It is built to reduce volatility. That matters if the money may be needed in a moderate term. But really it is a decision manage our emotional responses, and therefore the chance that we do stupid things in response. People experience loss with greater intensity than the same amount of gain. And that’s not irrational. Losing half my portfolio value now would mean I couldn’t retire if I wanted to. And likely change how I live moving forward Doubling it just means I will leave a bigger estate.

Reducing volatility while limiting negative impact on returns over time is the goal.

Two asset classes that are strongly positively correlated fail to do that. Classes that are not well correlated do it better.

If classes that are not well correlated also each have fairly strong returns over longer time periods then returns can even be increased compared to either alone when rebalanced with some regularity.

I’m not sure that a small allocation to gold achieves that even as I cite articles that claim it does. But I am convinced that including it in the portion that is not equity does a better job of reducing volatility and maintaining return than that portion being all bonds.

87

Would you be?

GLD is up 202% since May 2016. Was 123 then and is 249 now. And since the two have NOT moved in lockstep during that time if you had rebalanced with discipline you would have achieved BOTH decreased volatility AND even better return than either alone.

That’s just one time period but … not a good one to make your point.

88

My point was that I wouldn’t be selling it at a loss, not that at that one point in time gold wasn’t ahead.

As I mentioned, that money goes all the way back to 1996, which is when I started working. But Fidelity uses 2016 as the cost basis because that’s when I transferred it into them. It also treats all the money saved from 1996 to 2016 as a single large lot, so it’s impossible to calculate my actual return. Well, not without digging up my old paper statements from 30 years ago.

89

I have the same problem. It’s one of the things that complicates moving the money from one custodian to another.

90

Perhaps you’ve never heard of Ray Dalio. From Google Search summaries:

I am NOT claiming Mr. Dalio’s recommendation is sound. Just countering a quoted claim.

(OTOH, I’ve recently noticed that many of the (AI-generated?) summaries Google presents in response to searches are totally wrong.)

PS: I had to play around to get “quote” tags to work. Is this a known problem?

91

2/3rds of the reply to which you’re replying was about Dalio.

92

How about the hedge of: Grandma has gold stashed somewhere. We ought to visit her and bring some cookies. Just to ‘stay in touch’.

93

Mostly seen this concept as the basis of simplistic reasoning for consumers to buy gold. Gold is certainly a better hedge against inflation than cash is, so call the number on TV and buy some. If they don’t get ripped off and do own some gold it’s nowhere near the worst thing they could do with their cash.

94

Huh. I thought your point was

95

Refer to this post:

Hedge fund managers are not economic theorists (but their views are worth discussion). (No worries, btw, I’ve made similar oversights here. I blame Discourse.)

Yeah, I don’t consider that cite. You need to dig into the original source.

Hoo-boy: it may be close. Gold bullion can be lost or stolen. Commissions on gold bullion are high at both the sell and buy end, relative to stocks or any investment mediated by a broker. Gold bullion is a hassle to buy and sell, relative to low cost stock mutual funds. And that’s assuming you conduct due diligence and buy and sell from low margin vendors.

Gold is highly volatile. Terrible returns can follow impressive returns and long run returns aren’t especially good. You could be selling at a terrible loss. Gold doesn’t pay interest. Ok, lottery tickets are worse, but jeez. Cash in the cookie jar is also worse, but if you’re going to put effort into buying gold without ripping yourself off howzabout just moseying over to Vanguard?

As for cash, money market funds on average pay above inflation.

There’s a smart case for gold, but it’s subtle, debatable, and generally doesn’t involve gold bullion. If you have no familiarity with investment concepts such as, for example, beta, you have no business buying gold IMHO. I suppose there’s a smart case for other tangibles such as stamps and baseball cards, but again we’re not discussing core investments and we’re not even discussing non-core investments.

Negatively correlated 2% would be awesome though, if you can get it. Diversification would permit you to reduce your risk at a reasonable sacrifice of returns. Very roughly speaking, this is the underlying principle of long/short hedge funds, which are fairly popular. (Also, during recessions, some investors pine for 5% returns.)

96

You’re right that I wasn’t clear. But I also said:

Which, on review also wasn’t entirely clear. I mean that if markets move inexorably up over sufficient time (historically true), then being x% off of highs isn’t a loss to you.

I also said

So to expand on that, since the real data are lost, I know that my first year working in 1996 I put about $4000 (not including match) into an S&P 500 index via the 401k. I remember this because I was very proud of my young self for saving that money, and it was more than 10% of my gross (man, 1996 was a long time ago) That $4000 should be worth about $51,000 and returned an annual 9.59%
Per this link: S&P 500 Historical Return Calculator [With Dividends] – Of Dollars And Data

And so yes, if the market drops by 25% I’m still way ahead, because by my math gold was $734 in December 1996, and that represents a CAGR of about 4.6% to today’s price.

I’ll not deny that we can find periods where gold is ahead. But over the long term it’s a dog. And that was my real point. A 25 (or even 40) year old saving for retirement isn’t going to benefit from holding gold. And if you can predict WHEN gold will outperform equities, as I said elsewhere, you’d be a billionaire.

97

Okay. And Bonds are dogs against all in on equity too, over many decades.

I personally agree that, at an early point in investing, volatility is not actually risk, if one has a temperament to stick with the plan even during a period of the market dropping by 50%. Some do not.

And that IF one has enough in income and cash to wait out a major drop staying otherwise aggressively positioned is fine, despite the common advice to be more conservatively positioned.

But let’s assume an investor who is at a point that volatility scares them. They are willing to sacrifice some on return maximization to reduce volatility, maybe at a point in life that a drop would risk needing to eat the seed corn before the market can recover.

That is a function of diversification of asset classes. The fact that gold is poorly correlated with stocks and bonds, sometimes actually spiking up under conditions of major drops in equity, helps make it a good fit for that function, as part of a basket.

You don’t have to. You just need to be less lazy than I am and actually be disciplined with reallocation, be it by dates, or by amount of change from target. When equity markets have dropped and gold has increased, reallocation will have you move from gold to equity. When the market recovers and gold stayed flat or dropped reallocation has you shaving off from equity and putting into gold. And bonds. And others as per your asset allocation target.

That potential increase of return for level of volatility by a discipline of selling highish and buying lowish is another theoretical benefit of diversification that gold can be part of.

98

I certainly think so. I hardly have anything in bonds, and what I do is all in my brokerage account which is partly for retirement but also for things like paying for that new kitchen.

I’ll acknowledge that when I get a bit closer to retirement I’ll need some more in less volatile vehicles, but I’ll do bonds before I do gold (and, BTW, I’m pretty happy with SPHY because it returns 7.75% yield; that’s where the kitchen money sits, because my issue isn’t spending the money it’s the disruption of taking the kitchen apart)

99

Sure. But looking at this, I don’t see much of a correlation between gold increasing and recessions (shaded in gray):

100

It’s not a great graph. FWIW here’s Forbes’ analysis:

There have been eight recessions between 1973 and the most recent in 2020. In all but two of these, gold has outperformed the S&P 500. The exceptions were in 1981 and 1990. 1981 was unique in that the Federal Reserve chairman Paul Volker aggressively raised interest rates to combat the massive inflation of the 1970s. 1990 was a mild recession and it came at a time when the world’s central banks were net sellers of gold due to good macroeconomic conditions globally. Gold did very well in the other six instances. From six months before the start of the recession to six months after the end of the recession, gold has rallied 28% on average and outperformed the S&P 500 by 37%.

They think its performance during inflation, the actual question the OP, is more complicated:

On balance, gold seems to benefit from inflation but less so if the expectations are for the Fed to act decisively against it. Simply put, gold likes inflation but doesn’t like the higher rates or the strengthening U.S. dollar that the Fed may engineer to combat it.

And there’s just insufficient data to comment on stagflation.