Even a Nugget of Gold Can Dramatically Improve Your Pension Safe Withdrawal Rate (SWR)

From a purely rational point of view, it is difficult to argue against this point of view.  There are few asset classes that don´t produce a tangible benefit but gold is one of them.  Stocks participate in a company´s growth and earnings, bonds and cash generate interest, commodities such as copper have industrial utility and food commodities keep the world fed.   Gold is very much the exception.  In 2020 only 8% of the gold produced went into industrial applications. 92% of gold production was for Investment or Jewellery manufacture – sectors where value is based upon sentiment, not utility.

Despite gold´s lack of utility it has always been viewed as a precious metal in all senses of the word and has been used as or formed the basis of currencies for over 2500 years.  Prior to the development of paper currencies during the 19th-century gold and silver were the base currencies in most countries.

The value of the US dollar was fixed in relationship to gold up to 1971 and until then the dollar was a fully convertible currency – the dollar could be exchanged for gold at the Federal Reserve.  Back in the 1920s, one US dollar would have been worth (in fact physically exchangeable for 0.045 ounces of gold, but by 2020 one dollar would have purchased just 0.0005 ounces – a devaluation of the dollar against gold of over 9000%!

It is quite possible to see that gold´s role as a financial asset could be usurped.  Whilst it is a finite resource the true reserves are uncertain so production is increased and decreased in accordance with its value, but the total amount of gold above ground is always increasing. The supposed advantage of a digital currency such as Bitcoin is that there is a theoretical maximum of 21 million coins so its value should not be affected by over-production so its value should (eventually) only be determined by demand.  Only time will tell if these electronic currencies move from being speculative bets to become stores of wealth.

Perhaps not unsurprisingly the organization entrusted with promoting gold, The World Gold Council, presents a strong investment case for gold.  It identifies some unique characteristics of gold as an asset class that makes it a valuable portfolio diversifier:-

Negative correlation with the stock market during market crashes – as a traditional flight to safety asset gold increases in price when the stock market is in crisis

Positive correlation with a rising stock market – this would seem to contrary to its negative correlation above but the argument is that during good times gold demand for jewelry and industry increases. They state average annual returns over the last 50 years have averaged 11%, comparable to equities.

High Liquidity – gold trading volumes exceed those of Treasury Bills and UK gilts and at an average of £131bn per day during 2020 are similar to volumes of the S&P500.

Inflation Protection – the purchasing power of gold has outperformed all major currencies

Analysis is Handicapped by Limited Historical Data

It seems strange that we have limited data available to analyze the investment case for gold but the reality is we have only 50 years of data available as it was only in 1971 that it was freely floated against the dollar – or depending upon your viewpoint the dollar was freely floated against gold!  We have 100+ years of bond and stock data available so any analysis of gold as an investment class will have far less certainty than that for equities and bonds.

Post 1971 the dollar surged in value and increased by over 1400% during the 1970s.  But as the graph below shows, gold investors from 1980 to 2000 would have been disappointed and it was only post-2000 that gold shows some spectacular but bumpy progress.

We have had three significant market crashes during the last 50 years and in each case, gold showed a strong negative correlation to the stock market:-

There is normally a price for everything.  If gold can protect a portfolio against market crashes what is the cost?  We would normally expect to see the cost of holding gold through a lower long-term growth rate compared to stocks.

Proponents of gold as part of an investment portfolio would like as to believe that there is negligible loss of growth through holding gold.  The Gold Council publish the chart below of the 20-year performance of gold against other asset classes:-

Comparing relative performance over longer periods is also problematic.  During the 1970s after the dollar was no longer tied to gold, the price of gold soared by more than 1400%.  This was followed by over 20 years of near-stagnation followed by strong but volatile growth up to 2020.  It really is difficult to draw any conclusions or predict future growth patterns and it would certainly be unwise to think that the around 3% underperformance of gold compared to equities over 50 years is an accurate predictor of future performance.

The only conclusion that can be drawn from the data is that gold is powerfully negatively correlated with stocks when markets crash.  If the most predictable role for gold is portfolio protection during market crashes the big question is which is more effective – gold or government bonds?

In the case of the UK market, the answer must be gold.  Its performance was far superior to gilts during the 1973/4 and 2007/8 crashes and equal to gilts during the tech crash of 2000.

The dilemma that investors are faced with is clearly illustrated in the graph below that shows the variation of Maximum Drawdown (the maximum fall in the value of a portfolio) and Safe Withdrawal Rate (SWR) with changes in the equity content of a portfolio:-

(UK portfolio of the total stock market and 15-year gilts 1970 to 1990, 30 year retirement periods)

The maximum Safe Withdrawal Rate (SWR) is obtained with 65% to 75% in equities but this also coincides with the maximum drawdown (decline) of up to 60%.

Many retirees would be very unwilling to accept such a drastic fall in the value of their retirement savings.  Increasing the bond holding in the portfolio isn´t an effective solution either, as with only 40% in equities the SWR falls to 2.8% – a 20% reduction in a retiree´s income yet the portfolio will still be subject to a potential 50% decline in value during a market crash.  Reducing volatility and drawdown by weighting the portfolio towards bonds has a high price and is not that effective.  This is where gold comes into play.

Gold in a Portfolio

CONCLUSION

Based on the last three market crashes gold can significantly protect a portfolio from severe market downturns and is more effective in this than holding government bonds.  Perhaps more significant for retirees in drawdown is that as little as 5% of gold in a drawdown portfolio will increase the maximum amount that can be safely drawdown as retirement income and allow the equity content of a portfolio to be reduced without greatly reducing its income potential.

The evidence that gold can provide growth just a few percentage points behind that of equities is far less certain as the 50-year performance of gold is distorted by its stunning growth in the 1970s after the ending of convertibility and the dollar-gold pegging.  Uncertainty over the likely future growth rate of gold and the distortions of its performance in the  1970s must lead to treating gold heavy portfolios such as Harry Browne´s Permanent Portfolio and the Golden Butterfly with a degree of caution.

 The evidence is that gold should belong in a drawdown portfolio but perhaps not to the extent that analysis of the last 50 years indicates. My own drawdown portfolios are now targetting around 13% in gold, down from 20%, which I think is a reasonable compromise between a healthy SWR  and the risk of lower growth.