Portfolio diversification is an important part of investment strategies and one of the cornerstones of Modern Portfolio Theory. The recent financial crisis and global recession put most common strategies to the test, however, and raised questions about the diversification properties of so-called alternative investments such as commodities, hedge funds and real estate. Amid the chaos, gold not only outperformed most of these alternative investments but also was one of the few assets, along with government-issued securities, to deliver a positive return on the order of 4% in 2008.
We at the World Gold Council, the market development body funded by the world's biggest gold mining companies, spend much time analyzing the performance of gold in a variety of financial and macroeconomic environments. As such, we have found that changes in the price of gold do not correlate with changes in the prices of other financial assets regardless of the health of the financial sector or broader economy. Over the past 10 years the average correlation of gold to U.S. equities and Treasury bills has been virtually zero.
While the average correlation of gold to government and corporate bonds, world equities and REITs ranges from 10% to 30%, gold exhibits a low correlation with other commodities.
The correlation of gold to the S&P Goldman Sachs Commodity Index (GSCI), a production-weighted benchmark index, is 31% over the same period. Out of the 20 major commodities that the index generally comprises, all but silver have a correlation with gold of less than 50% (ranging from 10% to 46%). It's also worth highlighting that there is no stable positive correlation between gold and oil prices. While the average crude-to-bullion correlation is 30%, it can vary from 40% to 60%, depending on economic conditions.
Gold's lack of correlation with other assets is underpinned by the fundamentals of demand and supply. It is primarily a luxury consumption good (68% of its five-year average annual demand comes from jewelry, mostly from India and other Asian countries), but it also has an important role as an investment vehicle (20% of average demand) and in industrial applications (the remaining 12%).
In recessionary periods when consumption spending falls, gold's role as a safe haven increases investment demand for gold, mitigating the impact on price and keeping gold's correlation to other assets low. On the supply side, 59% of demand over the past five years has come from mine production, 28% from recycled gold and 13% from official sector sales.
Sources of demand and supply are in turn affected by a whole host of factors. Some factors, such as inflation and currency movements, are tied to developments elsewhere in financial markets, but many more are particular to the gold market, such as India's wedding season, new discoveries of gold and the central bank's strategic reserve decisions.
Contrary to popular belief, gold is not an especially volatile asset. Over the past 10 years gold's annualized price volatility has been just 15.8%, compared with 41% for oil, 21.7% for the GSCI and 18.4% for the S&P 500. In addition, unlike most other assets, gold is more volatile on the upside than on the downside, as negative economic news tends to induce flight-to-quality flows out of riskier assets and into gold.
Historically, gold has exhibited an inverse relationship to the dollar - on the order of 60% - making it an effective hedge against dollar weakness. The price of gold also tends to rise when inflation spikes up. During years in which inflation exceeded 5% since 1971 (when gold was allowed to freely float), gold rose by an average of 14.9% in real terms, far outperforming other financial assets such as equities, bonds and other commodities.
In sum, gold's deep, liquid and accessible market, coupled with its low correlation and tame volatility relative to many other assets, as well as its long history as a dollar and inflation hedge make compelling arguments for its inclusion in both private and institutional investor portfolios.
Juan Carlos Artigas is an investment research manager with the World Gold Council. He and his team publish research papers and investment statistics on the council's Web site