Is Gold an Inflation Hedge?

Gold reached yet another record high yesterday, closing at $1,290.20 an ounce on the Comex division of the New York Mercantile Exchange.

The Federal Reserve recently indicated that it stands prepared to provide greater support to the U.S. economy. The financial markets translated this into additional purchases of US government securities, greater liquidity, a weaker U.S. dollar and the specter of inflation.

Let’s continue to explore gold. Is gold an inflation hedge?

If we consider the 35 year period, 1975-2010, inflation averaged 4.03% according to the Bureau of Labor and Statistics. But this really does not tell the story. If we look above at the price of gold, we see that it was flat or declining for about 20 years. Inflation was hardly non-existent during this period. Do you remember interest rates in the late 70s and early 80s?

The following chart shows the relationship between inflation and the price of gold over the past decade.


We have been in a period of very low inflation. However, gold has experienced a rather noticeable run up. So, at least over the past decade, the notion that gold is a hedge against inflation does not seem to be supported by the data. Particularly in the past decade and currently, gold seems to be acting largely independent of inflation.

Today the concern is rather equally balanced between inflation and deflation. There is little evidence that gold serves as a hedge for either.

Harvard doesn’t Beat the Market

The Wall Street Journal recently (September 10, 2010) reported that Harvard University’s endowment fund posted a return of 11% for the 12 month period ending June 30, 2010. Harvard’s endowment, at $27.4 billion, is the largest college endowment.

Harvard manages the endowment internally through the Harvard Management company. The team managing the endowment is prominent in the endowment community for its positions in real estate, private equity and venture capital.

The median return for large endowments for the period was 12.3% according to Wilshire Associates. The Dow Jones Industrial Average returned 18.9% in this period. A portfolio of 60% stocks and 40% bonds would have outperformed Harvard’s endowment with a return of 12.6%.

I would add that the 60-40 portfolio would have undoubtedly taken on much less risk.

This is yet another piece of evidence that suggests that attempts to beat the market are fraught with risk. In addition they are burdened with significant expenses. The Harvard Management Company provides compensation that is comparable to that of the leading Wall Street money management firms.

The most intelligent way for individual investors to manage their portfolios is through low-cost, passive investments.

Gold Hits New High

Concerns about the stability of European banks drove gold to a new all-time high on Tuesday, September 7, 2010. The Wall Street Journal ran an article on Tuesday suggesting that the stress tests for European banks may have understated their exposure to government debt. The fear is that some European nations may yet default on some of their obligations. Gold closed at $1,257.30 an ounce.

So, is it time invest in gold?

Investors are rewarded for investing in gold only if they can find someone else who is willing to pay more for it than they did. This is not a problem as long as the price of gold is going up as it has been for the past several years. But when the price of gold is going down or moving sideways, investors who hold gold may not be able to sell it without incurring a loss.

This naturally leads to the history of the price of gold. Has the price of gold risen in a manner that has made gold an attractive investment?

The world went off the gold standard in the early 1970s. Previously the price of gold was controlled by the world’s largest central banks under the terms of the Bretton Woods system which was negotiated after World War II. So, we’ll focus our attention on the period that followed.

In 1975, 35 years ago, gold was priced at an average of $161 an ounce. Today gold is trading at roughly $1,250 an ounce. This is a growth rate of 6.0%.


Source: http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx

However, notice the price of gold actually drifted lower for the better part of this 35 year period. How would you have felt had you purchased gold in the late 70s or early 80s?

To put this in some perspective, the Standard and Poor’s 500 Index returned 11.7% from 1975 to 2009. (Source: Standard & Poor’s Index Services Group)

Based on this data alone, gold does not appear to be a particularly attractive investment.

Ibbotson on Investing

The current issue of Money (September 2010) includes an interview with Roger Ibbotson (pp. 105-108). Ibbotson Associates publishes the Ibbotson SBBI Classic Yearbook which analyzes historical data for stocks, bonds, Treasury bills, and inflation. It is commonly the reference for the historical returns quoted in the financial press.

Ibbotson is a professor of finance at the Yale School of Management. He is the founder and former Chairman of Ibbotson Associates, a financial research and information firm that was acquired by Morningstar in 2006. He is also the founder, Chairman, and Chief Investment Officer for Zebra Capital, a hedge fund.

In the article, Ibbotson was asked about investing in index funds vs. actively managed funds. Here’s his response:

“To the extent you’re in index funds, you’re going to have less risk because you’re eliminating the impact of active management. You’ll also have lower fees. In actively managed funds, your risk level goes up, as will hat you pay in fees. The question is, do you think the funds you pick can compensate for the extra risk and higher fees? On average, the answer is no, but there can be a subset of investors who outperform.”

I would add there will always be some investors who choose actively managed funds and outperform the market. The issue is how long they are able to do this. Few will be able to do it consistently year after year. The question you have to ask yourself is whether you can be among them.

If you are not confident about beating the market, after expenses, then you are better off in a low-cost, passively managed portfolio. You will not beat the market. You will earn the returns of a broadly diversified portfolio. Your investing expenses will be a fraction of the typical actively managed fund.

If you review Dalbar’s research on investor performance results, you’ll find that if you achieve “average” results, you’ll be doing much better than the vast majority of investors, including large institutional managers.