For ten years before 2005, gold acted as a safe haven for stocks, but not bonds. In addition, it only functioned that way for a limited 15 trading days during periods of extreme shock.
In the long run, gold is not a safe haven, the study indicates. "Investors that hold gold more than 15 trading days after an extreme negative shock lose money with their gold investments."
Over the long run, however, the price of gold moves with the Consumer Price Index, according to a recent study by professors Eric Levin at the University of Glasgow and Robert Wright of the University of Strathclyde, both based in Glasgow, Scotland.
The bottom line: Investors should not expect soaring gold prices unless near-term inflation fears heat up. At best, over the long term financial advisors who hedge their clients' stock and bond positions in gold can expect that the negative correlation of gold with stocks and the low positive correlation with bonds will help a portfolio's risk-adjusted rate of return.
Only small stakes of 1% to 2% of assets in gold in low-risk portfolios and 2% to 4% gold in medium risk portfolios are needed to improve risk-adjusted performance, according to a 2006 study by the World Gold Council in New York and New Frontier Advisors in Boston. The study examined returns from 1974 through 2005.
The results showed the following:
Gold competes well with small-cap and emerging market equities as a diversifying asset.
Gold acted as a good inflation hedge by returning 2.1% when adjusted for inflation over the past 30 years ending in 2005.
Gold delivered twice the inflation-adjusted return on T-bills and sported a -15% correlation with T-bills. It had no correlation with bonds and a relationship of only 7 basis points with large-cap stocks.
Although keeping a small stake in gold can act as a portfolio hedge, other financial research shows that it is not a sure thing in the long term. Diversification with gold lowered a portfolio's beta value but did not improve a portfolio's return per unit of risk, reported a 2005 working paper by Ryan Daly of the University of Albany published on the Social Science Research Network.
"Over the last ten and 30 years, adding gold to a portfolio did not generate alpha," Daly's study says. "Although risk and volatility are reduced, the returns are not enhanced and the value-added benefits of gold are not produced."
To improve gold's use as a portfolio hedge, some money managers suggest using the Dow/gold ratio as a beacon to make changes in the percentage allocated to gold or precious metals mining stocks (see chart). Dividing the Dow Jones Industrial Average by the price of gold shows how many ounces of gold it takes to buy a unit of the index.
Typically at the peak, when the Dow Jones/gold ratio is high-as it was in the mid-1960s and from 1999 to 2000-stocks are overvalued and overbought and carry record high price-to-earnings and price-to-book ratios. For example, in 1999, the average stock sported a price-to-earnings ratio of 33, and stocks were selling at more than five times book value, according to Golden Sextant Advisors in Boston. This period was also characterized by the excessive ownership of stocks and by excessive liquidity and credit-a scenario that typically leads to a decline in stock prices and an increase in gold prices.