Most investors would agree that the last decade has been extremely difficult. U.S. equities have generated a 5-percent annual return, which is well below a historical average of around 9 percent (as measured by the Standard & Poor’s 500 Index).
The 37-percent decline in the S&P 500 in 2008 remains a recent memory, too. The market environment has been volatile for a number of reasons, including a lack of confidence after the most recent recession, along with high debt levels in Europe and much of the developed world with no easy solution.
To navigate the markets, investors need diversification among stocks, bonds and cash. In addition, I believe an investment in gold adds further diversity.
Gold has attracted investors for thousands of years, both as a currency and as a store of wealth. In more recent history, gold has behaved as a hedge against both inflation and deflation. Most investment portfolios are invested in stocks and bonds, and gold’s low correlation to these traditional assets may enhance a portfolio’s risk-and-return profile.
For example, while global equity markets declined substantially in 2008, gold advanced 6 percent. Furthermore, since 2005, there have been 34 months where the S&P 500 return was negative and in over 60 percent of these negative months, the return for gold was positive, although there is no guarantee this will continue.
One of the primary benefits of gold is its perceived safe-haven status in uncertain times. I am asked about the future price of gold and my answer is the same as when I am asked about how much the stock market will go up next year: I do not know and nobody knows.
One reason to include gold in an investment portfolio is as a defensive measure against a loss of confidence in the markets. If the price of gold falls, this may reflect a more positive market sentiment, in which case the investor’s equity holdings should be doing very well.
Conversely, in a more difficult market environment, an investment in gold can act as an insurance policy and preserve capital.
Another reason I believe gold should be considered in an investor’s asset allocation is as a hedge strategy against the risk that central banks continue to increase the supply of their currencies to solve a global debt problem (in other words, “quantitative easing” or the “printing of money”).
Europe’s issues have been in the news almost daily over the past two years, and the fiscal situation in the United States is not much better. Interest rates are near 0 percent here and in many developed-world countries, and one way to provide further easing is through the printing of money and the weakening of currencies for competitive reasons. Printing money can lead to the depreciation in the value of currencies and support gold as an alternative store of value.
I do not believe gold is a bubble at its current price. At the peak of Japan’s equity bull market, Japanese stocks made up more than 50 percent of the world’s stock market capitalization. In the late 1990s, almost every investor was excited about technology stocks.
Although the gold price has risen, it does not seem to have reached a bubble level of broad ownership. Even with radio and television commercials marketing gold to the general public, many investors remain skeptical of gold and do not own it.
Two large investor groups are increasing their ownership of gold: emerging markets and central banks. Until recently, central banks were net sellers of gold, but now they are accumulating gold for diversification and to own an alternative to U.S. dollar assets.
Emerging markets, particularly China and India, are attracted to gold, and in 2011 these countries accounted for 42 percent of global gold demand.
If investors are interested in gold exposure, there are several ways to own it. Physical gold bullion is the safest form of investing in gold, but it requires a secure place to store it. Investors can also easily invest in professionally managed investments that own physical gold, as well as gold-mining equities.
The risk of loss in investing in gold can be substantial. You should therefore carefully consider whether such investing is suitable for you in light of your financial condition.
Similar to equities, gold can be a volatile investment in the short term. But gold’s appeal in an investment portfolio is its ability to improve overall diversification.
Investors should consider allocating a portion of their portfolio to gold, especially in a world with so much uncertainty.•
Cohen is a managing director with Stifel Nicolaus & Co. Inc. in Indianapolis. Views expressed here are the writer’s.