Enrich Your Future 19: The Gold Illusion: Why Investing in Gold May Not Be Safe

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out to me because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. Specifically, we're going to be going over chapter 19. Is gold a safe haven asset?

00:35
Larry, take

Andrew Stotz 00:36
it away. Yeah.

Larry Swedroe 00:37
So I think the best place to begin this story is the reason that I hear the most. There are generally two reasons people want gold in their portfolios. At least want to consider it. I think we probably could agree the most common one is it's a good inflation edge. Okay. Well, unfortunately, that's only true if your horizon is about a century long. And I don't know anyone who has an horizon of a century, although the Yale endowment might have one of that long, no individual does so even at 10 years, the research shows that gold is not a good inflation hedge at that horizon, the best hedge against inflation, of course, is to own, at least in the US. US investors who own an inflation link bond in the US, they're called tips. There are other countries that also offer inflation linked bonds, and that gives you perfect hedge against it, against inflation. But if someone doesn't believe that evidence, this is the empirical research. Here's a specific story that I think should convince anyone you should not buy gold because you think it's a good inflation age. So in 1980 gold hit a high at that time of $850 an ounce. 23 years later, it was something like 270 and inflation averaged 4% a year for that 23 year period, roughly. So that meant that gold lost 86% of its real value during that period. If something's a hedge, it should lose zero. So anyone who claims gold is a good inflation hedge over any normal investment horizon is just simply wrong. So that's number one over a long horizon, it is true. And the great example is this, if you go back to the time when Jesus walked the earth, a Roman Centurion could buy a good suit of clothes, armor for about an price of an ounce of gold. Today, an ounce of gold is about, I think, $2,500 something like that. And goodbye you a nice Armani suit and tie and, you know, shirt and shoes and so you got that so you business armor the hedge. It gave you the hedge, but you had a zero return for 2000 years. So to me, that's a pretty lousy investment. Okay, now that doesn't mean that gold may not play a role in its second reason that people consider it, and that's as a safe haven against bad geopolitical risk. People could think of Nazi Germany, for example, or you know, Cambodia, or Russia or China, or you know, these kinds of places, especially you know India and China. People there board gold for that, those types of very reasons. One of the things I point out, before getting to the research on that, is, keep in mind that, for example, the Jews in Germany who had gold the Nazis came with machine guns and took their gold. So unless you have the gold stored someplace where you could leave and get to it, it's not going to do you any good. Maybe nice as jewelry you're wearing it, but it won't serve for the reason that lots of people you know actually do buy it with that said, here's some more evidence that gold serves as a safe haven sometimes. But nowhere near as often as people think. There in the periods when the stock market goes down, okay, it's about 17% of the months when the market goes down, gold goes up. So that's good the Pro or sorry, 17% of the time when go when the market is down, gold also goes down. 19% of the time when the markets go down, gold goes up. So it's close to a 5050, coin flip, where the gold will act as a hedge when the stock market is going down. So that doesn't look to me like a very good hedge, especially when two thirds of the months the markets are going up, and so you're not gaining much of an advantage when it's going down. Having said that there are other periods when geopolitical risks show up and gold does well, so I don't have a problem with people allocating a very small amount to their portfolio, but they should only do it if they're prepared to earn lousy returns most of the time, like 23 years, and then when the risks do show up and governments become powerful, getting spend too much money, you get spectacular returns, you know, for a short period of time, right? But the only way you earn those returns if you're able to stay the course, and I don't know too many investors who are able to wait out 20 or longer year periods and not only stay the course, but rebalance. So that's a real problem, I would tell my advice was never shouldn't. Probably own more than 5% of your portfolio is gold, but if you really feel that you need a hedge against geopolitical risks, you know that's okay, but you have to remember today gold is an opportunity cost of Almost 5% because that's the riskless rate in T bills, and if you own an ETF a convenient way, that might cost you another 30 basis points or whatever. So five and a quarter percent, so gold has to go up, you know, five and a quarter percent a year for you to be even right. And gold is also not taxed that efficiently. It's, you know, stacked as a combination, at least in the US, somewhere between capital gains and ordinary income as treated as a commodity. So that's my thinking. You know, on gold, it does act as a safe haven on occasion, but there are also many times when it doesn't and it actually doesn't even hold up. It actually goes down. And it's a 5050, coin toss historically, you know, slightly favoring gold. When the equity markets go down, the gold will also go down. And one reason is markets often go down when the Fed tightens monetary policy, and that means the cost of owning gold is going up because you're giving up that carry, giving away the interest income you're going and tightening fed means likely less inflation risk, so gold goes down as well. So that's my thoughts on gold.

Andrew Stotz 08:43
So inflation hedge you talked about, and it's not really an inflation hedge. And if you run an inflation hedge, a

Larry Swedroe 08:50
very long horizons, right? I can say a minimum of like, 2530 years.

Andrew Stotz 08:55
But if inflation is your worry, then tips is a better, much better. Not

Larry Swedroe 09:01
even close. Yep.

Andrew Stotz 09:02
Okay, and that is a perfect hedge. Okay, it

Larry Swedroe 09:06
moves exactly with at least the reported CP. Your inflation rate may be higher or lower than the Consumer Index, depending upon what your mix of spending is, but it's a perfect hedge against the reported inflation and

Andrew Stotz 09:23
gold as a safe haven in the case of geopolitical events and stuff occasionally, and, you know, but not always for sure. And then the other one is currency. You know, for a lot of people, they look at the US dollar, and they think, at some point this, this currency is going to collapse, and I don't know where to put my money. Do I put it in Chinese? Do I put it in Euro? Do I put it in, you know, where do I put that? And so some people say, Oh, well, I think I'm going to use gold as a hedge against the US dollar collapsing.

Larry Swedroe 09:56
You know, the evidence shows of the long term, gold is. Not a good hedge against currency risk. It can be a good hedge, as we've said, over the long term, against inflation, and the only reason the dollar should collapse is if you get high inflation. So I'd rather own tips than on

Andrew Stotz 10:16
gold. All right. Okay, so tips, pretty much does the main thing that most people are thinking about when they go into

Larry Swedroe 10:22
you get a real rate of return today, guaranteed of about 2% right, instead of no real expected return with for gold over the long term, it's been zero for 2000 years. So

Andrew Stotz 10:36
let's, let's imagine now, you know, I do a lot of correlation analysis, just like for fun, like looking at three year rolling correlations of different asset classes or different ETFs or whatever, relative to, let's say, the S, p5, 100 as an example. And the problem that you so when I'm thinking about it, I'm thinking about, obviously, I don't want to damage my returns too much, but I'd like to find something that has a low or negative correlation. If you do something like, let's say, Take REITs as an example, or commodities funds, which may include gold, what you find is that, generally, these things are highly correlated to the market most of the time. So they, although they may have some good returns, they're not really a diversifying asset. Then when you look at Gold, you see that, well, the correlation is zero. Yeah, I would like to have negative, but I definitely don't want to have, like, highly correlated, or else I just hold that in the s, p5, 100. So, but, but I also know that, okay, the cost of having zero correlation is, you know, it is going to lower my overall portfolio volatility by a small amount, but it's also going to damage the return. So I would say that, you know, lower correlation is, in theory, better, but if it damages your return, then you have

Larry Swedroe 11:58
to think of that as the cost of insurance against inflation risk or geopolitical risk. Five, you know, up until 2020 or right through 2022, even you know, their carrying costs of gold was zero. The Fed had the interest rates, my opinion, extremely foolishly and eventually created all kinds of problems, bubbles in asset prices and stuff, but the carrying costs of gold was zero. So fine, you want to own gold, it's not costing you anything terms of carrying costs today. That's not true, right? If I what I'm using as what I think is a better, you know, protection against inflation risk is owning private credit that's senior, secured and sponsored by, you know, high quality private equity firms. The average loan to value is about 40% in the fund that I'm in, and the yield is 11 and a half and it's all floating rate, and the historical default losses are under 1% so I'm getting 11 and a half percent and have inflation, but now I am taking some economic cycle risk, because you get a soft procession, right and before that's a big price, that's a huge premium right over say T bills, which are five, so I'm getting six and a half percent, which is an equity like return, historically, with literally about 1/5 of the downside risk, or even less than that of equities. So to me, that's a superior way, especially if you take the allocation from stocks, because now you've lowered the overall risk of the portfolio, right? Because, you know, they're like, 20% or less risky than stocks, and yet you got that kind of return. If you take the allocation to gold from equities, now you're really lowering the expected return of the portfolio

Andrew Stotz 14:12
and and what? What about the role of bonds? If you take a general let's say a bond, ETF, let's just say government bonds. Let's forget about credit risk and things like that, and take a Vanguard type of ETF of bonds, what you're going to find is the correlations are even lower than gold. So over time, that's not true. What are the correlations between? Yeah,

Larry Swedroe 14:36
people don't realize this, but the long term data, people tend to think of the correlation of stocks and bonds is negative, and that's because we had this great moderation when the Fed was suppressing interest rates right and suppressing economic volatility as well. But the long term. Data is the correlation between stocks and bonds is about point one seven, if my memory serves so it's actually positive, and it can happen at exactly the wrong time, which, by the way, happens 50% of the time with gold. We said right, roughly 50% of the time when the market's down, gold is down, but 2022 we had stocks down double digits in the US, and bonds down double digits in the US. And that's happened, I think, three or four other times in history. So it doesn't always work that way. Okay, so I like shorter term boxes that hedge against inflation.

Andrew Stotz 15:44
So let's say that somebody builds a portfolio of equity. And let's say that, you know, they've got that. Let's just say it's 100 million, $200 million $500 million Portfolio. So let's say they can only trade in ETFs. Let's say they're in Thailand as an example. They're not going to go sign up at a fund. Management Company in America as an example. And they have what they want for their equity exposure, whether that's us, whether that's global, let's just say they have the VT fund that owns every stock in the world. So you know, they've got their equity exposure. And it's, it's, it's as low as you can get, the risk on that you're still going to be exposed to market risk. With that market cracks, it's going to collapse. But from a diversification perspective, within equity, you kind of own every stock. So let's just start from that point, super simple. And now the person saying, Okay, I want to reduce the risk of my portfolio. And that means I want to add, I want to allocate somewhere between, you know, five and $20 million out of a, let's say, let's just take 100 million. Just to keep it simple, I want to allocate two to 10 million into something that's going to, you know, help me to reduce the overall volatility of this portfolio? What would they add?

Larry Swedroe 17:02
Yeah, so the first and the easiest way for people, simplest just go buy a short term bond fund, say a Vanguard short term ETF, something like two years or something. So you have very little duration risk, very little inflation risk, and that would be one way to do it the and you if inflation does pick up, and that's what you're concerned about, you're fine. I don't think there's much risk on the reinvestment risk side, because of all of the printing of money around the globe by central you know, by governments. So, you know, it's certainly possible rates could go down, but maybe they go down to two and a half. You know, you have to remember, central banks in the world are targeting inflation of two. They don't want to see it less than that. Historically, treasury bills have yielded 50, 6070, basis points above that. So let's call it 270 for where you would expect the T bill would be in that world. So you're at, you know, five, 475, to five today. So the most it likely would go down, unless you're in a severe crisis or financial is 2% but if you get high inflation, it could easily go back, like it did in the 70s, into double digits. So I think the risk is much higher, that they go up, and especially with budget deficit problems around the globe. So that would be one thing, but, and

Andrew Stotz 18:41
just, and just to highlight for a second, for people that may not completely understand it, really short term bond fund really is getting pretty close to cash, right, right? So, you know, the simplest way someone could say is, I have $100 million and I have 10 million or 5 million in cash and 95 in equities. Well, you are, in theory, diversifying in that case, but here you're going to get a little bit of return and the like. So what would be your next step?

Larry Swedroe 19:07
Yeah, what I think is a superior overall way of doing things is to hyper diversify the risks. So you could add something like reinsurance. So the reinsurance fund today that I'm invested in ETF, just, just so, unfortunately, it's not an ETF, yeah, I don't even know if it's available to foreign investors, but it's called, it's stone ridges reinsurance fund. A symbol is S, R, I x, the expected return this year was about 23% and I would guess the expected return next year will be similar. The fund is actually up 23% this year, just a matter of luck, but it has no correlation to stocks at all. Like gold, like a two year, right? It does have more downside risk in a really bad year, might go down 25 30% but the expected return is 23 and there's no correlation, and it has a bit of an inflation edge, because part of the at 23% is the return on Treasury bills they hold until the year is over, because they have to hold the reserves in case bad events happen. So if rates go up, as they've done, four years ago, they were earning zero on their cash. Today, they're earning 5% and up until a couple of months ago, they were getting five minutes. So that's one which

Andrew Stotz 20:44
is great. But my in my situation I'm explaining for the listeners, is that they can't buy they be, they got to be in a relatively large and liquid ETF. Let me ask you a question about the short term bond fund. Is there any reason to hold a tips fund if you have a short term bond fund,

Larry Swedroe 21:02
yeah, because if you have the tips, you can lock in the long term rate. If you think that's attractive when it was negative, I wouldn't have done it today, you're up around 2% or so. And I think that's a reasonable one. I remember in the early 2000s it was at 4% and my entire tax advantage portfolio was all in tips. I thought it was the body of the century, and it did turn out to be that way, 4% real return, risk free. To me, that's far better than equities, especially today, when the expected real return, you know, probably isn't 4%

Andrew Stotz 21:49
if we think about it, from a 2030, year horizon, you know, we're talking long term horizon. Someone doesn't want to be in and out of these different things. They're happy with their VT fund as an example. Should they be adding the short term bond, ETF and tips ETF? Should they? How should they think about the Diversified that's

Larry Swedroe 22:09
tax advantage, money you probably want to own tips, because the yields, real yields, I think, are attractive. Again, not super attractive, but quite reasonable, and you can lock in that real yield if you're short term you know, you have that reinvestment risk showing up, but you eliminate the inflation risk with tips. You have no reinvestment risk because you could buy a longer term tip and lock that real rate in, you know. So that's a big if you own the short term tip for the 10 years before 2022 I mean, you were earning negative real returns or zero, all right, and you know, so then it might have been better to own the shorter term bond fund, but you weren't getting anything either there. I mean,

Andrew Stotz 23:03
Neither of these instruments are going to provide a huge return like equity, really, I would say the person that's got that 100 million dollars is really putting it in there for the diversification benefits. And so if you look at the short term bond fund, and we looked at the TT, Tip, Tips, ETF, which one do you think would have a better reduction in volatility over a 2030, year period?

Larry Swedroe 23:29
Well, the volatility will be lower in the short term bond fund because you don't have the risk of real rates moving. But that shouldn't concern you, if you like, the two year current real yield on tips, all you have to do is hold it to maturity. What do you care? What the volatility is? In the interim, it's irrelevant. You're going to get a guarantee of a 2% real return plus whatever inflation is. So that volatility shouldn't matter, right? It's not. It's silly to even think about it that way. Okay?

Andrew Stotz 24:03
And last question is, we've got these two instruments that we're talking about as potential risk reducers for this, you know, long term, 100 million dollars in equity. Is there any other, anything else that you would add, I know in the research that you reference in the chapter you talked about Pim Van fleet's research about gold, and he talks in his research about getting low risk, building a portfolio of low risk stocks. Does that make sense?

Larry Swedroe 24:34
Yeah, you can, you know, I'm not a big fan of that strategy, and because, if you own low volatility stocks, okay, well, let me say it this way, there's a low volatility stocks on a risk adjusted basis of outperformed high volatility stocks, which is a violation of the capital asset pricing model that's. Big anomaly, which is why the capital asset pricing model is wrong, and everybody knew it like immediately when the cap M came out. But it's a nice theory allows you to help you think about how markets work. But it's just not true. But if, if you have a low vol fund with a market beta of point eight, you sort of have 80% exposure to the market. The Mark goes up 10% you're going to get eight likely, and if it goes down 10% you'll only lose eight and low volatility strategies have only worked and added higher returns when they were in the value regime, so they were cheap and low beta, and today, because of the popularity of these strategies, it's kind of neutral, so there's no premium. So why own them now? They actually got so popular they became growth stocks, and then that low volatility performed very poorly. The most important thing for investors is they should screen out the high volatility stocks out of their portfolio. You do not want to own them, but the average retail investor loves them because they look like lottery tickets and they hope to hit the lottery, but the average return is god awful. So, but let me add this. I think if you can accept the fact that you will bear some downside risk, okay, I would much rather own real assets than gold, because they have our expected real return. So, for example, real estate over the long term, real asset prices go up because part of the cost is land and buildings, construction costs, and real estate will act as a good long term edge. And remember, gold only works as a long term edge, right? And you real estate is basically provided similar returns to the equity market, but might be a better inflation head from that perspective. The other asset, which people, I think can buy, certainly I know, are available in private markets, but they may be available are infrastructure,

Andrew Stotz 27:21
because infrastructure, ETFs and the like,

Larry Swedroe 27:23
yeah. So they, for example, own toll roads and water facility and things that when prices go up, those things, you know, raise their prices with the inflation rate. And it can act as a hedge that way as well. So I'd rather own something that has a real expected return, rather than something with no real expense. But you should probably always have a sufficient amount of the really safest, most liquid, like treasuries or tips, so you can rebalance in a bear market. Right? The other assets may be more difficult because they're going down maybe at the same time. Um,

Andrew Stotz 28:06
and you mentioned real estate. The problem that we face with real estate is, every time you go to think, Oh, I'm going to invest in real estate, all you find is REITs and then, and then you're all of a sudden, you know, you there's a rental income, and it's like, as opposed to, let's just say, the most simplest situation of this guy, this man or woman who has $100 million is that, well, take ten million and buy a piece of property in the city that you like, and, you know, own a piece of land, build a house, something like that. Would that be the diversification benefit? Nope, that's

Larry Swedroe 28:38
really the wrong thing, unless you're an expert in real estate, and they'll make the mistake of think confusing the familiar with the safe. Oh, I know that building. I know that air. It's like owning one stock. It's got a unique undiversified risk of that location, that region. Maybe it's exposed to some industry, certainly exposed to one country, and it's exposed to one type of real estate, where, if you own a broad Real Estate Fund, you own hotels and warehouses and data centers and all kinds of, you know, commercial real estate, residential real estate. So that's the way I would prefer to own it, in a very broad, lower cost vehicle, if you're using public then Vanguard's fund or dimensional fund would be very good choices.

Andrew Stotz 29:30
And are these? Are they? What are they owning? Are they? Is it just a bunch of

Larry Swedroe 29:36
Vanguard owns an index of real estate that excludes mortgage REITs. I think they also exclude prison REITs. So it owns hotels and warehouses and data centers and, you know, apartment buildings and all kinds of stuff. So you're highly diversified. And at least the US fund is us. You can own International. As well. I'm sure of that they're available,

Andrew Stotz 30:05
interesting. Well, the real estate one is a challenge, because every time I see a liquid, large liquid, REIT, I correlate it to the US to the market, and I find a very high correlation. And then I ask myself, and then and then and then, to make matters even worse is that, what what many of these REIT funds? Let's take an ETF as an example. What they own is listed reads which are already in the index. So I'm just carving out a sector and doubling my exposure to that sector.

Larry Swedroe 30:36
But the correlations aren't perfect. You're still getting a benefit and you're getting an expected, real return. And remember that the correlation with stocks we may hold like you're getting down markets, like maybe 2022, both stocks and REITs went down, or Oh, eight, they certainly both went down, right. But over 10 year periods, it may be very different. And remember, gold is not a good inflation hedge, even in 10 years. But I bet, if you looked, I haven't looked, but I bet the correlation with inflation and real estate is probably higher and Okay, certainly over long horizons real estate would be a reasonable inflation edge, and that's where gold so would you rather own something with a real expected return of zero or one with a real expected return, you know, maybe in the 4% or something like that range? So let's be higher today, because, read, prices were so distressed.

Andrew Stotz 31:40
So let's go. Let's then wrap this up by going back to this person. They're not highly sophisticated, but they want something super simple. They got $100 million they can invest in ETFs. They've got that 100 million and they've got a 30 year time horizon. They're not short term, and they don't want to buy and sell. They want to set it and forget it. To some extent, they're 100% exposed to equity through, let's say, the VT fund. So they own every stock in the world. They're not interested in doing a lot of different stuff in that. That's okay for them. They're they're thinking of, I don't know, five or 10% of their portfolio going into something. We've talked about short term bond funds, we talked about tip ETF, we've talked about low volatility stocks, and we've talked about real estate. We've talked about real estate and going out and buying a piece of land versus real estate investment trusts and other types of funds, and we've talked about infrastructure funds. Okay, now, now they've heard that discussion and they're going to say, okay, so what would be the one thing that would be the best for me, over a 30 year period to add five or 10% to this portfolio to reduce risk of volatility a bit. What would you say?

Larry Swedroe 32:50
I would say you start with tips, and that should be your first five or 10% that should be mandatory in the portfolio, if you will. And then you could look at adding some of these other assets. And if you have access to private markets, which I know, higher net worth individuals probably have, you know, most places in the world, you could own private real estate, private credit. And the cost of investing in these types of vehicles is coming down. It's come down dramatically in the US. So or I never would have invested in private credit 10 years ago. Now, 10% of my portfolio is in private credit, and 10% of my portfolio is in private real estate, which is much more tax efficient in the US than REITs are.

Andrew Stotz 33:41
So what a comprehensive discussion about this, starting with gold, and then going through and realizing, okay, it's not all it's cracked up to be, and therefore there are other alternatives. We've been through different alternatives. Uh, excellent discussion. So I appreciate that Larry, and I'm really looking forward to the next chapter, which is chapter 20, and you titled it a higher intelligence. And I just want to read the quote, because it's such a great one by Victor Hugo that says there is one thing stronger than all the armies of the world, and that is an idea whose time has come. And I guess, since Trump just won the election, maybe that was the idea whose time has just come. So excellent. And for those of you that want to continue to follow the discussion with Larry, find them on Twitter at Larry swedroe And also on LinkedIn. This is your worst podcast host, Andrew Stotz saying, I'll see you on the upside. You.