Worried About Inflation? Look Beyond Gold.

Savers are increasingly looking to gold as a way to address rising inflation and for a good reason. The Federal Reserve’s policies in 2020 have massively expanded the supply of money. And more money could lead to higher prices down the road. In anticipation of this concern, some investors are considering gold investments to hedge, or protect against, higher inflation. But a key question for many investors is whether gold is an appropriate way to protect against rising prices.

Our work suggests that relying on gold to protect your savings against inflation may not be optimal. In fact, a survey of historical financial and economic data suggests that assets like stocks and bonds could be better suited to mitigate inflation. More importantly, a diversified portfolio of stocks and bonds provides the benefits of inflation hedging while reducing overall risk to your savings compared to investing in gold alone.

Why Should You Worry About Inflation?

So, what is inflation, and why should you care about it? Well, inflation represents a steady rise in the price of goods and services over time. For example, a can of soda that cost your grandmother ten cents in her youth might now cost you a dollar. And today, inflation is evident in everything from higher housing to education and health care costs.

There are many ways to measure inflation. One often-cited inflation measure is the Consumer Price Index (CPI). Every month, government workers survey the prices of hundreds of products and services comprising the CPI basket. The relative importance, or weights, of the items in the CPI basket, is intended to reflect how most Americans spend their paychecks. And while individual prices might ebb and flow from one month to the next, it takes a broad move higher in the basket to signal rising inflation in the economy generally.

Where does inflation come from? Well, there are many schools of thought on the origins of inflation. Ask a Monetarist, and they’ll tell you that central banks, with their printing presses, and low-interest rates are the cause of inflation. Ask a Keynesian, and their response might be more nuanced with an emphasis on factors like economic supply and demand and the scarcity of goods or services. Either way you cut it, more money in the financial system and higher levels of future economic growth could lead to faster inflation in the years to come.

Why is inflation important to you? Well, inflation is a vital concept to understand because, when left unchecked, it can erode your purchasing power. That is purchasing power representing the number of goods or services that a dollar saved today can buy you tomorrow. Since 1990, US CPI has risen at an average annual rate of 2.4%. And at this rate, purchasing power is cut in half every 30 years. In other words, while you may have spent $100 on a given good 30 years ago, today, it will cost you $200 thanks to inflation.

This point is notably crucial if you’re saving up to buy a home, pay for college, or plan for retirement because not accounting for inflation might leave you short when it comes to paying for these essential financial goals. That’s why it’s not only enough to just put some away money for the future, it’s also vital to grow your money in a way to generate a healthy return that beats inflation.

Is Gold an Optimal Inflation Hedge?

For thousands of years, gold has been relied upon as a form of currency and a store of value. Now gold’s worth comes mainly due to its scarcity. This precious metal is so scarce that all of the gold mined throughout history could fit into three Olympic-sized swimming pools. Until the 1970s, the value of the US dollar was tied to a gold standard, and today, global central banks are expanding their holdings of the precious metal as part of their currency reserves.

While there are many reasons to view gold as an essential store of value, history has shown that this precious metal is not the best hedge against inflation. For example, since 1990 gold has increased from $391/oz to over $1,500 by the end of 2019, giving it an average annualized growth rate of 4.8%. How does this stack up against inflation? Over this same 30-year period, as mentioned before, inflation has averaged 2.4%. While gold has bested inflation in some respects, the return on gold is lower than what we would find with other financial assets. A point we’ll explore in just a moment.

Besides the issue of underperformance versus financial assets, there are other challenges associated with holding gold. First, gold can be costly and cumbersome. Buying, transporting, and storing large amounts of gold comes with various expenses. And while storing gold at home can alleviate some of these inconveniences, doing so can expose your money to potential theft and loss. What’s more, many homeowners’ policies provide minimal coverage for the loss or theft of gold. So when your gold is gone, it’s gone.

Second, when it’s time to sell, finding someone to buy your gold, and getting a reasonable price might be difficult. Certainly, many gold dealers are willing and ready to pay cash for your yellow metal. Even so, fluctuations in gold prices can be as volatile as holding stocks, with a price that can fall as quickly as it rises. Therefore, while gold is on a tear today, the price a dealer will pay you tomorrow is less certain. Given its low return, high volatility, and high holding costs, gold may not be an optimal hedge against inflation. If protecting against inflation is a concern, you may want to consider financial assets.

Financial Assets as an Inflation Hedge

So, how well have financial assets held up against inflation? Well, generally speaking, data have shown that some financial assets, most notably stocks, have handily beaten inflation over the past 30 years. Since 1990, equities (as measured by the S&P 500 index) have appreciated 10.3% per year on a total return basis. This rate of growth has bested gold by a spread of 5.5%.

It’s true that many of the same factors that drive stocks higher are evident in gold price movements. Even so, while stock markets are largely seen as driven by supply and demand, the equity gains noted above reflect total returns or the return received with dividends reinvested. This concept of total return is vital because gold does not produce income. Its value is solely based on what an individual buyer or seller thinks the yellow metal is worth.

On the other hand, equity prices are driven by market demand for a given security and expectations of a firm’s earnings. Market participants are willing to pay increasingly higher prices for a stock in anticipation of a firms’ rise in earnings. These earnings typically grow through a combination of competitive advantages and pricing (inflation) adjustments that flow through to a company’s revenues and profits.

To this point, over the past 30 years, S&P 500 companies have been able to grow earnings at an annualized rate of 6.7%. From this perspective alone, we find that equities have a natural inflation hedge built-in through their ability to pass along rising prices to their customers. And it’s these intrinsic efficiencies that drive value to shareholders.

Other financial assets, like US Treasuries and corporate bonds, have also posted outsized gains against inflation and gold over the past 30 years. Much of this outperformance has been driven by several factors, including falling interest rates, central bank asset purchases, and investors’ search for yield. Even so, bond investors not only receive a return on the price of the bonds themselves, in many cases, they get paid interest while they wait.

Another thing to consider is that while the total market value of gold globally is around $10 trillion, in the US, total bonds outstanding sat at $46 trillion in the first quarter of 2020. Globally, this figure is well over $100 trillion. And given higher liquidity and marketability, bonds generally have exhibited lower levels of volatility. Add in the earnings power of equities, and historically higher returns, there is a stronger fundamental case for holding financial assets over gold as an inflation hedge.

Getting Paid to Take Risk

One final way to think about the benefits of holding gold versus other assets is to consider how much you’re paying to take on investment risk. One standardized measure of this risk-to-reward tradeoff is the Sharpe ratio, a concept we explored in a prior report. From an investment perspective, the Sharpe ratio helps you compare two or more assets to determine whether the return you’ve received per unit of risk is higher or lower. The higher the Sharpe Ratio, the higher the implied risk-reward tradeoff. How does gold stack up?

Compared to holding large-cap stocks or US Treasuries, gold offers a lower rate of return per unit of risk taken. This observation is notable since gold has returned less than US Treasuries over the past 30 years yet has a volatility measure comparable to stocks.

Even when we expand this measure to include home prices (another poor inflation hedge we’ll discuss in a later report), while gold price appreciation beats home values, you’re getting paid less on a risk-adjusted basis. Taken together, compared to other investments, gold is likely to pay you less to take on relatively the same amount of risk.

Bringing It All Together

If gold is not an optimal inflation hedge, where should you put your money? How much inflation and when it will arrive is mostly uncertain. What we do know is that when economic uncertainties rise, market volatility often increases as well.

Rather than trying to find one place to invest your money to protect against inflation, you might want to consider holding a diversified basket of stocks and bonds. Doing so might help protect against inflation and help mitigate market volatility when economic uncertainties rise.

As we’ve written about in the past, diversification is one crucial way to reduce portfolio volatility and smooth out investment returns for the long term. Studies have shown that increasing the number of securities held can reduce overall volatility in an investment portfolio. Therefore, if your goal is to invest for the long term, make an effort to diversify your portfolio across various securities and asset classes to help reduce risk.

Our work suggests that holding a simple 60/40 portfolio of stocks and bonds over the past 30 years protected against inflation, reduced investment risk, and provided generally higher risk-adjusted returns than gold alone.

Worried About Inflation? Gold Alone Might Not Cut It.

Preparing for inflation is a vital concept that all investors should carefully consider. Not accounting for rising prices, particularly at a time of unprecedented central bank policy, could leave you falling short of crucial financial goals. While some investors might look to gold as a way to protect against rising prices, history suggests that the precious metal might not be the best inflation hedge compared to several measures.

In fact, financial assets have a better track record of protecting against inflation. What’s more, holding a diversified portfolio of stocks and bonds protects against inflation and can help smooth the ups and downs in the markets. The bottom line here is that if you’re looking for a way to hedge against inflation, gold alone might not cut it.