Gold: Not an Effective Hedge Against Inflation

By Larry Swedroe

Whenever equity asset classes experience bear markets, investors seek out safe havens for their investments. This is especially true in times of financial or political crises.

One whose popularity runs in cycles, with short bursts of enthusiasm or "frenzy" as the price soars, followed by long periods of it being ignored, is gold. And while the price of gold has fallen from its peak of over $1,000 in March 2008, we can still say that it is in the "frenzy" stage.

The main argument made by advocates of gold is that they believe that it is a good hedge against inflation. For the period from 1935 (when the price of gold was fixed at $35 an ounce by the Federal Reserve) through October 2008, gold did provide a positive real return of 0.6 %. Unfortunately, not all individuals have horizons of 73 years. We need to consider more-realistic investment horizons. This is especially true for retirees (for whom 73 years would be far greater than their horizon), or those nearing retirement, as they face the greatest risk of inflation negatively impacting their lifestyle. We address that issue by considering the period since 1981 - the last time there was a "frenzy" for buying gold.

In 1979, inflation peaked at a rate of 13.3 %. That was followed by an increase of 12.4 % in 1980. The price of gold rose as the fear of inflation increased. While we admit to a bit of data mining, the following example demonstrates that gold is not a good inflation hedge, unless perhaps your horizon is "infinite."

Let's assume that to provide a hedge against future inflation an investor decides to purchase gold at the end of 1980 with the price at $641 an ounce. Over the next 27 years (1981-07), inflation rose at an annualized rate of 3.4 %. If gold were an effective hedge against inflation, its value at the end of 2007 should have been at least $1,528. Yet, it was worth just $833 (an annualized return of just under 1 %). In other words, an investor in gold experienced a reduction in purchasing power of 2.4 % per annum, or a cumulative loss of purchasing power of about 55 %. For an investor who was unlucky enough to purchase gold at its peak of $850 an ounce on January 21, 1980 (as some undoubtedly did), the inflation-adjusted price would have had to have been in excess of $2,300 by the end of 2008. If gold can provide negative real returns of that size over almost a 30-year period, it cannot be considered an effective hedge against inflation.

Even worse is that our example does not consider the costs of investing in gold. Strategies have no costs, but implementing them does. The most direct way to invest in gold is to purchase actual gold coins or bars, which may require additional transportation, storage and insurance costs.

Another common option is to use the futures market. The problem there is that like all easily storable commodities, gold trades in contango - the futures price is higher than the spot price by an amount equal to the cost of carry (financing, storage and insurance costs). Therefore, over time, the investor, while having the incremental trading costs involved in rolling over the futures contracts as they mature, also has the cost of the contango.

A third way to invest in gold is by purchasing shares of an ETF such as the SPDR Gold Trust ETF (GLD). The fund has an expense ration of 0.4 % (plus the costs of storage, etc.). Thus, no matter the method used to gain access to gold as an investment, the already-poor real returns would have been negatively impacted.

While commodities as a broad asset class (as opposed to gold specifically) are too volatile to act as a hedge against inflation, we believe they are a more superior hedge against inflation than gold. The price of gold itself has very little impact on the economy or the rate of inflation. On the other hand, while a commodity index such as the S&P GSCI does include gold, it also includes a wide range of commodities that can have a significant impact on the rate of inflation (i.e., Energy, Industrial Metals, Livestock and Agricultural commodities). Note that for the period 1981 through November 2008, the S&P GSCI returned 6.7 % per annum, outpacing inflation by over 3 % per annum, and far outpacing the return on gold.

Summary

While gold has provided a slightly positive real return over the very long term, the price movement is far too volatile for gold to act as an effective hedge against inflation. For those investors who desire to hedge the risk of inflation, the preferred instrument is TIPS, which directly hedge the risks of inflation.

Comments

[lance sjogren:]

TIPS are not a viable inflation hedge because they hedge against the "cooked" inflation figures put out by the govt.

I believe shadowstats.com has some stuff on this. The more honest way inflation used to be calculated shows we have been running much higher inflation than what the phony inflation gauges that are currently used show.

Today's inflation statistics are not a gauge of prices but rather an instrument used by the govt to convince the public that the cost of living is going up a lot less than it really is.

2008 Dec 23 02:06 PM

[NOWHEREMAN:]

Lance: the Gov. started this dodge because Congress passed COLA adjustments for Social Security. Since its elimination would not look good to the Retiree population, the Fed removed food and energy from their calculations.

This was done ostensibly to remove wild fluctuations but in reality it was to subdue the amount of increase in SS payouts. A trailing 12 month average could smooth out the fluctuations but since the payouts could never decrease, they have opted to retain the present method.

When inflation jumped in the Bric nations, food and energy were included. I do not know of any other nation which uses this method. Do you?

2008 Dec 23 02:21 PM

[Dimi from B...:]

I propose that holding physical gold is not only for hedging against inflation, but an insurance against the unthinkable. I have been paying auto insurance for ever and have never had an accident. Should I then say, I should never buy auto insurance? Whould you not pay a small fee for a potential catastrophic event? Even if remote? In troubling times gold goes up, when trust returns, gold goes down. Gold price (bar government manipulation) is very rational based on trends, fear and greed just like stocks and housing. Cheers

2008 Dec 23 02:23 PM

[Tranquilmed...:]

Is this the same financial writer who in his books refers to diversification as large cap, mid cap and small cap stocks and throw in a little growth and value for good measure? If you had followed his advice your wealth would of vanished this year. The Modern Portfolio demigods are dead and so are their silly bull market metrics: standard deviation as a measure of risk, bell curves, efficient markets, r squared, and the most costly (to taxpayers), valuation at risk models.

We are in a bear markets for stocks that is no where near over. Gold is extremely attractive given the irresponsible policies governments around the world are following. Someone should inform the U.S. congress they are broke and have no money to bailout: banks, insurance companies, auto manaufacturers, home builders, states, and on, and on, and on.

Gold has maintained its relevance as a source of wealth for 5,000 years. What has been the longest standing fiat currency Mr. Swedroe? You just happened to leave that out of your biased article.

2008 Dec 23 02:28 PM

[tew:]

This "analysis" ignore the interest earned on the capital covering the futures contracts. Since we are talking about an unleveraged strategy here, we need to assume that the investor fulling funds the futures purchase. The easiest assumption is that those funds are invested in short term treasuries. Once we fix this error in the analysis, the results are very different.

2008 Dec 23 02:42 PM

[bonifiedhus...:]

The author's argument makes little sense. The argument is that the current price, which, based on a high real-price in 1982, has provided substandard returns. For that reason, investors looking for a real-return should look elsewhere. If the inflation-adjusted price to match 1982 is $2,300/ounce, who is to say that outcome is unlikely?

2008 Dec 23 02:58 PM

[DiggerUK:]

You can double post your fraudulent claims like some cheap hack if you want.
Just don't try fooling anybody.
My criticisms are on your other post.

2008 Dec 23 03:05 PM

[Machine1964:]

Does anyone remember what the 3 wise men gave Jesus?
Frankincense, Myrrh and Gold.

Whatever happened to Myrrh and Frankincense? The same will eventually happen to Gold.
At least with a Fiat currency, it is backed by the goods and services that are deliverable by an entire nation. What backing does gold have? It only has the value that we give it.
One day we will decide, just like with Myrrh and Frankincense, it has no real value.

2008 Dec 23 03:10 PM

[DougM:]

aitvaras, I believe you're mistaken about the CPI - it does include food and energy costs, and this year social security recipients got almost 5% as a COLA resulting largely from these factors. CNBC often quotes the so-called "core" rate that excludes these items, which, as Bill Fleckenstein likes to say, is "inflation excluding inflation". That number can be very misleading, but it's not the number used for COLAs etc. Now, you could make the argument that the CPI used for COLAs is also inaccurate due to hedonic adjustments, improper weighting, owner-equivalent rent, etc., but that is a different argument.

2008 Dec 23 03:19 PM

[Chris B:]

Easy, angry goldbugs, easy!

It may be more accurate to say that gold is not an inflation hedge, but is actually an inflation EXPECTATIONS hedge. In 1980 or 1981, inflation expectations for the next several years were in the double digits as everyone fell into the trap of assuming the next few years would continue the trends of the last few years. When inflation expectations dropped to the low single-digits in the mid 80's - 90's, gold reverted to its jewelry and electronics value and stayed there, even as low but persistent inflation continued for years. Gold rose and fell along with people's inflation expectations for the future, not with inflation itself. In that way, it is like a revolving options contract on future inflation expectations being higher than current expectations. Regardless of actual inflation rates, if future expectations are lower than current expectations, gold will be lower in the future, and vice versa.

The author is right about the S&P GSCI being a better hedge against actual inflation and his numbers prove it - insults and invective notwithstanding. If government inflation numbers are an understatement of actual cost of living increases, then gold has performed even worse vs. inflation than the author estimates.

As Dimi points out, the other reason to own gold is so that you can have something tangible to buy food or bribe your way out of the country if complete war, anarchy, or dictatorship occurs. Physical gold may also act as a futures contract on the increase of such expectations - with the option to cash out at high prices if you believe such expectations are unfounded. This may explain the much talked-about difference between physical and "paper" gold prices, although I'm sure the dozens of extra middlemen in the physical market account for most of it. Big bullion dealers don't pay retail at the coin shop, I assure you.

This model also explains why some gold owners seem intent on sharing their view that anarchy or hyperinflation is imminent - the expectations of other people about the future is what sets much of the current value of their investment and determines whether they will profit. Advertising that you own gold (even on internet posts) seems like a good way to get your gold stolen or confiscated from you if all hell actually did break loose. Thus, I conclude that the doomsayers who are constantly trying to convince anonymous strangers on the internet to buy gold either (a) could not possibly believe their own theories and are actually selling, not buying, gold or (b) they don't realize they are reducing their gold's utility to them as anarchy insurance or (c) have a book / subscription website to sell.

2008 Dec 23 04:01 PM

[frank90291:]

let's forget about the name calling and talk about history and what the "experts" say. ...... will some one please come up with a list of stocks, funds and ETF's that have done better than GLD in the last few years.......

2008 Dec 23 04:18 PM

[GMiki1:]

People who criticize the performance of gold don't understand that like every investment, gold, too, has to be watched and sometimes even traded (though physical should certainly be held over time and definitely held right now).

Whatever you do mindlessly will get mindless results.

I just sold some gold (not gold held in my hands) that had more than doubled over about four plus years. That was not a bad investment. I sold because I needed some cash, not because I don't still believe gold will do well and is now the very safest investment in the world.

2008 Dec 23 04:27 PM

[txpenguin:]

In 1913 when the Federal Reserve was created by Congress, gold commanded a price of $20.67 per ounce. If one assumes a current gold price of $850 per ounce, that works out to slightly less than a 4% per year return over the last 95 years. That is a lot better than stuffing paper money in a mattress. Gold might or might not be a good investment at any given moment, but it has functioned very well as a store of value over the years. When its price falls to its cost of production, as it did in 1998 at around $280 per ounce, it is a good buy.

2008 Dec 23 05:22 PM

[Vincent L:]

What about any correlation of gold with gold refineries?

2008 Dec 24 01:51 AM

[chux08:]

I mean look at the title of this article, Gold: Not an Effective Hedge Against Inflation. These Keynesian apples never fall far from the tree, especially when they discuss gold. What do you expect from one who's so allied with the value-less world of fiat paper currencies and those that'll stoop to any level in the sewer to maintain the status-quo? Gold's HISTORIC use and success as a store of value is unarguable to millions of people over thousands of years and is unimaginable in the world of paper money. Let's face it, the only reason the government likes paper money is that it's so easy for them to manipulate and devalue it in hopes of inflating their debts away. And it's the same over at the COMEX. Paper gold and paper silver exist for these bastards to manipulate. It's a RIGGED GAME anytime the government or Wall Street gets to make and play with....paper and authors like this will tell you to come on over and play. Trouble is soon as they see gold or silver, it's like daylight to a vampire in that it is a DIRECT VOTE against the paper pushers and their vile concoctions designed for the detriment of the many for the benefit of the few.
The revolution is coming....

2008 Dec 24 03:12 AM

[ABG:]

The author arbitrarily uses 1980, at the top of the 1980s market cycle, to support the idea that gold is a bad hedge against inflation. But, we are near the bottom of the gold cycle right now, not the top. The last 8 years of gold's appreciation happened in a time of deep calm and steady economic growth. It was not the result of fear and panic, as in the 1970s. The first year of panic was the second half of 2007 to 2008. So, the gold cycle is now just beginning, not ending.

Arbitrary choice of 1970, at the bottom of the 1970s gold cycle, as a date upon which to base an analysis will give a completely different picture, compared to the choice of 1980. The price for gold on the Swiss market was $42 per ounce. If you had bought gold in 1970, keeping it stored in Switzerland (because Americans were not allowed to own bullion until 1974), you would have had incredible gains to date, exceeding the official measures of inflation.

Of course, there would have been yearly storage charges, but, if you owned the S&P 500 index, you would have needed to pay taxes on the dividends, and on all the sales that you are constantly forced to make when various stocks are removed from the indexes. If you owned a passive mutual fund, you would have been more seriously impacted by taxes.

If the index creators just left all stocks on the index that started on the index, and never got rid of the dogs, your gains in stock investing would be non-existent. So, companies are always added, and removed, and funds that follow the indexes, or you, need to buy/sell in sympathy with these moves to keep your portfolio consistent with the index. This creates taxable events, and taxes reduce return. In comparison, gold is not taxable until it is sold. Most people never sell it, so the capital gain is never taxed.

At any rate, after taxes, you would have had a much bigger gain from a static gold investment, dated from 1970, than from investing the same amount of money in the S&P 500 in 1970.

That is not to say investing in the stock market is a bad idea. It is simply a bad idea at this moment in time. There will come a time for stock investing, but not is not that time. Right now, smart people will opt for gold. Even though the stock market will go up a lot in the next few years, from current depressed prices, all of these gains will be for show only. They will likely be merely nominal gains, even though I do think we will be seeing DOW 30,000 by 2011.

Because of the circumstances that surround us, over the next 5-10 years, stocks will arise primarily out of inflationary pressure created by the Fed in its quantitative easing program. In other words, after adjustment for the reduced buying power of the dollar, stock gains will be non-existent, at least for many years. Gold, in contrast, will probably go up in real terms, because of the increased levels of world instability, a continuing decrease in mine production in spite of higher prices, and simply that almost everyone wants at least a little bit of it (whether in bullion or jewelry) and the world population is growing much faster than the world's stockpile of gold.

2008 Dec 24 08:18 AM

[FWallace:]

National Geographic Magazine, January 2009... featured GOLD on the cover.

The inside story is very interesting but within the article theauthor states that global GOLD is on the decline and should deplete within 20 years. Man has stripped the earth worldwide for most of all of it's GOLD...

Please everyone pick up and read NG magazine next month's issue Jan'09.

2008 Dec 24 09:33 AM

[ritr54:]

The real question is not what an ounce of gold returns against other investments; it is what does an ounce of gold buy today and what does $35 dollars buy today vs. in 1935?

2008 Dec 24 12:48 PM

[gmcg:]

A bird in the hand is better than two in the bush -- old maxim. I prefer my one bird (physical gold) to two in the bush (paper gold investments) as I believe physical gold will always hold some value. I don't get much return on my paper money currently in money market funds and what will happen to the dollar is an unknown anyway -- or those that know aren't telling us. But I should be able to barter for a loaf of bread and some milk in exchange for physical gold.

2008 Dec 24 05:37 PM

[bthomas:]

bollocks.

2008 Dec 24 06:46 PM

[Reserved Fo...:]

You obviously don't understand gold, its function and ultimate value. Actually, the more important point is that you are writing a column and are clueless about what is money. Is it fiat paper that we are racking up in an incredible panic or is it gold which historically has held its value and has no counter party risk.

By the way, what has been your advice on stocks and housing over the past couple of years? You either see gold and trust it or you don't. We will soon find out the answer to what is money.

2008 Dec 24 09:16 PM

[Gedankonomist:]

You can buy 15 ml of myrrh oil on ebay for $22.50. Frankincense is a bit cheaper.

See what you get for Enron or Madoff stock.


On Dec 23 03:10 PM Machine1964 wrote:

> Does anyone remember what the 3 wise men gave Jesus?
> Frankincense, Myrrh and Gold.
>
> Whatever happened to Myrrh and Frankincense? The same will eventually
> happen to Gold.
> At least with a Fiat currency, it is backed by the goods and services
> that are deliverable by an entire nation. What backing does gold
> have? It only has the value that we give it.
> One day we will decide, just like with Myrrh and Frankincense, it
> has no real value.

2008 Dec 25 06:44 PM

[bthomas:]

In an inflationary environment gold is and has been and will continue to be a stable marker as the respective currency is in value decline. We are not currently in such an environment, but will soon be. Bernanke at the Fed an Paulsen at Treasury have been trying their damndest to ensure it is so. Look at the dollar index since mid Nov. Look at GLD same period. Long term gold wins. Short term gold wins. End of story.

2008 Dec 26 05:19 PM

[bthomas:]

Excellent, insightful comment. (rebuttal)


On Dec 24 08:18 AM ABG wrote:

> The author arbitrarily uses 1980, at the top of the 1980s market
> cycle, to support the idea that gold is a bad hedge against inflation.
> But, we are near the bottom of the gold cycle right now, not the
> top. The last 8 years of gold's appreciation happened in a time
> of deep calm and steady economic growth. It was not the result of
> fear and panic, as in the 1970s. The first year of panic was the
> second half of 2007 to 2008. So, the gold cycle is now just beginning,
> not ending.
>
> Arbitrary choice of 1970, at the bottom of the 1970s gold cycle,
> as a date upon which to base an analysis will give a completely different
> picture, compared to the choice of 1980. The price for gold on the
> Swiss market was $42 per ounce. If you had bought gold in 1970,
> keeping it stored in Switzerland (because Americans were not allowed
> to own bullion until 1974), you would have had incredible gains to
> date, exceeding the official measures of inflation.
>
> Of course, there would have been yearly storage charges, but, if
> you owned the S&P 500 index, you would have needed to pay taxes
> on the dividends, and on all the sales that you are constantly forced
> to make when various stocks are removed from the indexes. If you
> owned a passive mutual fund, you would have been more seriously impacted
> by taxes.
>
> If the index creators just left all stocks on the index that started
> on the index, and never got rid of the dogs, your gains in stock
> investing would be non-existent. So, companies are always added,
> and removed, and funds that follow the indexes, or you, need to buy/sell
> in sympathy with these moves to keep your portfolio consistent with
> the index. This creates taxable events, and taxes reduce return.
> In comparison, gold is not taxable until it is sold. Most people
> never sell it, so the capital gain is never taxed.
>
> At any rate, after taxes, you would have had a much bigger gain from
> a static gold investment, dated from 1970, than from investing the
> same amount of money in the S&P 500 in 1970.
>
> That is not to say investing in the stock market is a bad idea.
> It is simply a bad idea at this moment in time. There will come
> a time for stock investing, but not is not that time. Right now,
> smart people will opt for gold. Even though the stock market will
> go up a lot in the next few years, from current depressed prices,
> all of these gains will be for show only. They will likely be merely
> nominal gains, even though I do think we will be seeing DOW 30,000
> by 2011.
>
> Because of the circumstances that surround us, over the next 5-10
> years, stocks will arise primarily out of inflationary pressure created
> by the Fed in its quantitative easing program. In other words, after
> adjustment for the reduced buying power of the dollar, stock gains
> will be non-existent, at least for many years. Gold, in contrast,
> will probably go up in real terms, because of the increased levels
> of world instability, a continuing decrease in mine production in
> spite of higher prices, and simply that almost everyone wants at
> least a little bit of it (whether in bullion or jewelry) and the
> world population is growing much faster than the world's stockpile
> of gold.

2008 Dec 26 05:38 PM