Gold in a portfolio: safe haven, inflation hedge or just shiny?

In depth7 min read · 6 sources

For many investors, gold in a portfolio is a form of insurance: it is supposed to rise in crises when equities fall, and to protect against inflation. But gold pays no interest and no dividends, its price fluctuates almost as much as that of equities, and research shows that both promises only hold to a limited extent. This article puts into perspective what gold can do, how to hold it and how it is taxed in Germany.

What sets gold apart from other investments

• No ongoing income: gold pays neither interest nor dividends. Its return consists solely of price changes. When real interest rates are high this is a drawback; when they are low or negative, hardly at all.
• No intrinsic value in the usual sense: for equities and bonds you can estimate a present value of future payments; for gold you cannot. Its price depends on supply, on demand from jewellery, industry, central banks and investors, and on confidence.
• A global currency: gold is traded in US dollars. For investors in euros, currency risk comes on top.
• High volatility: in many periods, the volatility of gold is of the same order of magnitude as that of equities; there have been several long periods of falling or stagnating prices.

Gold as an addition: the effect on risk

The benefit of gold lies in diversification: because gold is on average barely related to equities, a small allocation can reduce overall risk, even though gold on its own is volatile. The formula for the volatility of a portfolio of two assets (see correlation) shows why:

Against this stands the expected return. Because gold generates no income, it costs return compared with interest-bearing investments if its price does not rise. Whether an allocation is worthwhile therefore depends on your expectations for the gold price and interest rates, and on how much the insurance effect is worth to you.

A safe haven? What the research shows

Baur and Lucey (2010) distinguish between two roles: a hedge is uncorrelated with equities or bonds on average; a safe haven is uncorrelated even in a crash. For the equity and bond markets of the US, the UK and Germany they find that gold is, on average, a hedge against equities and a safe haven in extreme downturns. The portfolio analysis shows, however, that the protective effect is short-lived: gold helps in the days of panic, not necessarily over a whole bear market. Baur and McDermott (2010) examined the question for the stock markets of many other countries and for individual crises.

“Safe haven” here means: not falling along with the market in a crash. It does not mean that the gold price itself is safe. In some crises it initially fell too, because investors sold everything they could sell.

Does gold protect against inflation?

The popular story goes: gold preserves its purchasing power over centuries. Erb and Harvey (2013) critically examine this and other claims. Their core problem: the real gold price (i.e. the gold price divided by the price level) fluctuates enormously and was historically very high at the time of their study. If you buy at a high real price, you can lose purchasing power for decades, even if inflation rises. On the other hand, the real price could rise even further, for example if the central banks of large emerging markets increase their gold reserves. They call this uncertainty the golden dilemma.

In practice this means: over very long periods gold may roughly hold its purchasing power, but over the periods that matter to investors (ten to twenty years) it is not a reliable inflation hedge. Inflation-linked bonds, whose interest is tied to inflation, work in a more targeted way (see real return). Over the very long run, gold lagged far behind equities in the US data that Siegel (2014) traces back to the early 19th century.

Gold and interest rates

Because gold generates no income, it competes with interest-bearing investments. When real interest rates are high, i.e. interest rates well above inflation, gold holders miss out on noticeable income. That tends to argue against gold. When real interest rates are low or negative, holding gold costs hardly anything. This link can be observed in many periods, but it is not a fixed law: central bank purchases, fear of crisis or demand from large emerging markets can also drive the gold price against the trend in interest rates. If you hold gold, you should therefore not bet on a particular path for interest rates, but treat it as insurance with a fixed allocation.

Gold in euros: the currency effect

The gold price is quoted in US dollars. For an investor in euros, the return is therefore the dollar return on gold combined with the change in the exchange rate.

Interestingly, the dollar has tended to strengthen against the euro in many crises. The gold price in euros then rises further. For European investors, this can strengthen the protective effect in crises. More on the topic in the article currency risk.

How to hold gold and how it is taxed

For exchange-traded gold bearer bonds with a right to delivery of physical gold, Germany's Federal Fiscal Court ruled (BFH 2015) that gains are not investment income but are to be treated like a direct purchase of gold; after more than one year between purchase and sale or redemption, they are tax-free. Within one year they count as private sales transactions. A pure gold ETF within the meaning of the European fund directive (UCITS) does not exist, because the directive requires diversification across several assets. That is why gold products are issued as ETCs.

Gold mining shares are no substitute for gold: they do react strongly to the gold price, but they carry company and stock market risk and often fall along with the market in crises.

For advanced readers: how much gold?

There is no generally correct allocation. Strategic portfolios with gold, such as the Permanent Portfolio with a quarter in gold or the All Weather portfolio with a smaller share (see All Weather portfolio), deliberately focus on crisis protection. Broad textbook portfolios often hold no gold at all, because it is not part of the market portfolio of securities. Commonly cited allocations range between 5 and 15%.

If you optimise the allocation, be careful: the results depend heavily on the period. Since 1971, the end of the dollar's gold backing, there have been decades with strong rises in the gold price and decades with losses. An optimisation on historical returns gives gold a lot of weight or none at all, depending on the starting year. It is more robust to see gold as insurance with a limited allocation fixed in advance and maintained through rebalancing, and to judge it by correlation and drawdowns rather than by return (see efficient frontier).

Ilmanen (2011) places gold and other commodities within the question of expected returns: without ongoing income, the long-term return of a commodity depends on price developments and roll yields, not on a risk premium in the usual sense.

How Portfolio Lab calculates it

In the Asset classes library, gold is listed as the gold price in euros, chained from a physically backed gold ETC, the gold future and, before that, monthly averages of the gold price from 1960, with ongoing charges of 0.20%. For tax purposes, gold with a right to delivery is the default: in the Backtest with German taxes, gains on positions held for longer than 365 days are tax-free; within one year, Portfolio Lab treats them approximately like investment income. Correlation and drawdowns are shown in the Assets analysis. Details are in the asset classes methodology.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.