Legendary investor Warren Buffett, who usually has a good eye for value, explained gold like this: “It gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
But gold isn’t just something that people dig out of the ground. It’s one of the best ways to hedge your portfolio – that is, to protect it when stock markets everywhere fall, like after the two 7% declines in China’s stock market this week.
As we’ve written before, cash is a great way of protecting your portfolio when markets fall. But one of the most effective hedges against market downturns has proven to be gold, because stock markets and gold are negatively correlated assets.
Correlation is the relationship between two or more assets. It measures what happens to the price of one asset when the price of a different asset changes. When they are negatively correlated, their prices move in opposite directions. This evens out your overall performance when things get bumpy.
The table above shows the correlation between gold and major Asian market indices. Over the past 5 years, returns on gold have had a negative correlation with stock returns. That means when markets go down, gold usually goes up – and when gold goes down, markets tend to go higher.
Most major Asian stock markets are positively correlated – that is, they all tend to move in the same direction at the same time. That means negative events usually affect all markets in the region. So if you’re invested in Singapore and Malaysia, the chances are good the two markets will rise and fall together. That’s not diversified.
But by diversifying part of your portfolio into gold, you can reduce portfolio risk and solve the egg truck problem. That way, not everything in your portfolio will move in the same direction at the same time.
Gold is also a good hedge against falling currencies. 2016 is looking to be another ugly year for ASEAN currencies in part due to a continued slowdown in China – Southeast Asia’s largest trading partner.
Gold is often viewed as a global currency and as a tangible store of value. The global supply of gold is relatively stable, as newly mined gold only increases the gold supply by about 1.7% per year. In contrast, currency values can easily decline if the central bank increases the money supply, or if demand for the currency falls.
An example of how gold can act as a hedge against a declining currency is what happened during the 2008 financial crisis. The U.S. Federal Reserve cut interest rates and started buying bonds as part of its quantitative easing program (in which it created more money to help drive up inflation) in order to support the U.S. economy.
In just six years through 2014, the supply of U.S. dollars in global markets increased almost five times. This increase in supply helped cause the value of the U.S. dollar to fall compared to other currencies.
But the price of gold took off. In 2008, gold cost less than US$800 per ounce. In the aftermath of the financial crisis, as the U.S. central bank dramatically increased the supply of money, the price of gold rose to over US$1800 per ounce.
But as the U.S., and world, economy emerges from the crisis, and demand for the U.S. dollar has increased, the price of gold has gone down – a perfect example of negatively correlated assets. During a very volatile period, investors holding gold were protected from potentially larger losses.
One easy way to add gold to your portfolio is through the SPDR Gold Shares ETF (GLD on the New York Stock Exchange). The SPDR Gold Shares is the largest physical gold exchange traded fund (ETF) in the world. You can also buy it on the Singapore Stock Exchange using symbol O87 and on the Hong Kong Stock Exchange as 2840.
When markets go up, gold doesn’t perform well. But when markets fall, it’s a hedge worth having.