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What to Know Before Adding Gold to your Portfolio

Wondering if you should include gold in your retirement portfolio? Adviser Tim Kenney lays out some pros and cons.

By Timothy Kenney

Gold has been back in the news lately as it is had a fantastic run so far in 2020. Because of a combination of economic uncertainty, negative real interest rates, and central bank stimulus, the price of gold is up ­­­­­almost 30% year-to-date. GLD, the largest gold ETF, has brought in almost $20 billion this year – neck and neck with the Vanguard S+P 500 index fund bringing in the most dollars in 2020.

Timothy Kenney

Retirees managing a traditional stock and bond portfolio might be wondering if they should add gold to their allocation as well. It makes sense – an asset known for appreciating during periods of uncertainty and inflation certainly fits the bill in this environment. But retirees that may not have invested in gold ETF’s before may want to do their due diligence as gold is a misunderstood asset class. Here are a few things to think about before adding gold to your portfolio:

The Case for Gold

What are some good reasons to add gold to your portfolio? First, it is an uncorrelated asset to stocks and bonds. Stocks and bonds are negatively correlated – so when stocks go up, bonds tend to go down. Gold behaves like neither one which makes it a great asset class when considering diversifying against core stock and bond holdings.

Second, there are environments where gold can outperform stocks significantly. Demand for gold can spike during times of inflation, uncertainty, and other factors. In the 70’s, we went through double-digit inflation, an oil shortage, and political instability. U.S. stocks were essentially flat during that period while gold went from roughly $40 to $850 an ounce. Stocks went through another lost decade in the 2000s suffering two separate bear markets, while gold had another great decade with double digit annual returns.

Right now, a metric used by gold investors is to look at real interest rates. Real interest rates are a way to calculate your actual return on bonds after factoring in inflation. Right now, with the U.S. 10-year bond yielding roughly .70% and inflation at 1.6%, your real interest rate after inflation is about -0.90%. Since the financial crisis, as real yields head toward 0 and go negative, tends to be a good environment for gold performance.

Globally tens of trillions of government bonds have negative yields even before inflation is factored in. In the U.S., the nominal interest rates of our bonds are slightly positive but our real interest rates are negative. Gold, which has an interest rate of zero, suddenly does not look so bad for an asset class that doesn’t generate interest like a bond does. Add in the global uncertainty from the coronavirus and this seems like an ideal environment to consider adding gold. But that’s not to say that every environment is ideal.

Gold does not generate income or cash flow and go through years or decades of underperformance

As mentioned before, gold does not generate earnings, dividends, cash flow, or interest. It is worth what someone is willing to pay you for it – and that’s it. At face value, gold is a commodity that is mined, refined, and used in production like any other commodity. But it has little industrial use and cannot be valued via supply and demand like other commodities such as oil or copper. Investors treat it more like a currency or asset class – but one that cannot be exchanged directly for goods and services like dollars or generate cash flows like a stock.

Warren Buffett, even though he recently revealed his purchase in a gold mining company this year, has expressed his views on gold as follows:

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

“The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.”

You can buy a bond or dividend-paying stock and it will at least pay you interest or a dividend while you hold it. Gold just…is. It can go years, and even decades without going anywhere and can act as a drag on your overall portfolio. Like all investments, it is important to define your sell discipline before you buy in.

Gold – Not Always a Safe Haven

Even though the current environment seems ideal for gold, it is still a volatile asset class. Some investors lured into buying it as a safe investment might be surprised at how it behaves at times. GLD, the largest gold ETF, went down over 45% from its peak in 2011 until 2015 while the Federal Reserve was in the middle of their last version of monetary stimulus. GLD also dropped almost 30% from March – November of 2008 during the depths of the financial crisis. Investors looking to hedge against market downturns would have been better off in treasury bonds or cash.

It has a mixed record on hedging inflation

It is also not as great an inflationary hedge as is historically thought as it does not necessarily move up in lockstep with an increase in inflation. The price of gold peaked in the early 80’s and despite an over 5% rate of inflation the rest of the decade the price of gold went from $850 to $380. The entirety of the 90’s was awful for gold as well. If inflation is a primary concern for you, other asset classes like TIPS and even stocks may act as a better hedge.

Own Enough Gold to Make it Worthwhile

Most gold allocation recommendations from asset managers seem to call for a 2-6% allocation in a diversified portfolio. Is that amount going to have a meaningful impact to your portfolio one way or the other? If you do want to own enough to make a difference in your portfolio returns, you have to ask yourself if it is really worth the potential opportunity cost of not owning income and cash flow producing assets instead.

Gold is a unique asset that seems to have as many fans as it does detractors. Investors trade it for different reasons, which proves difficult to determine why it performs as it does sometimes. But it has proven it can outperform stocks and bonds during certain environments and can be a good investment for investors that want additional diversification and an alternative to negative real interest rates. But investors that do invest in gold should be prepared for a volatile ride that can turn the other way quickly if real interest rates start to climb again.

About the author: Timothy Kenney

Timothy Kenney, CFP®, is the founder of TK Pacific Wealth, Inc., a financial planner located in San Diego, CA. Timothy acts as a financial advisor to both San Diego residents and clients around the country providing retirement planning, investment management, and tax advice. The firm works on a fiduciary, fee-only basis.