Gold: high risk, low returns

Gold hit an all-time high this past week, at one point rising above $1,400 per troy ounce.  With such great news, you maybe tempted to jump on the gold band wagon.  But watch out! The real numbers on gold aren’t as glittery as the media hype.

Gold vs S&P 500 Total Return

Let’s look at the performance history of gold over the last 35 years and compare it to the general stock market using the S&P 500 Total Return index.  (Click here to download the spreadsheet and data and follow along.)

From October of 1975 to October of 2010, Gold had a total return of 842% or an annual compounded growth rate of 6.62%.  That doesn't sound too shabby.  But wait!  There are a couple of major issues we need to take into consideration in order to determine the actual return an investor would have earned.

First, the IRS taxes gold bullion as a collectible, so long-term capital gains are taxed at 28% instead of the 15% on stocks. Even gains on gold ETF’s (exchange traded funds) that deal in gold as a commodity are taxed at the higher collectible rates. After applying a 28% tax rate, gold's 6.6% pretax return from 1975 to the present is reduced to only 4.8%. During this same time period, annual inflation averaged 3.82%, making gold's after-tax real return only 0.91%.

Now let’s compare gold's 0.91% after-tax real return to the return produced by the S&P 500.  During this time period in question, the S&P 500 had a total return of 3,803% or an annual compound growth rate of 11.04%.  After factoring in long-term capital gain taxes of 15% (maximum rate as of 2010) and the same inflation rate of 3.82%, the index had an after-tax real return of 5.36% or almost six times more than gold! To put it another way, $1,000 invested in gold would have grown to be $1,373 in real (i.e., inflation-adjusted) dollars. If that same $1,000 had been invested in an S&P 500 index fund, it would have grown to be worth $6,218.

Gold is high risk

Not only has gold produced less return than stocks, it has also been far more volatile. The standard deviation of gold's annual return was 22.28% between 1975 and the present.  The standard deviation for stocks, on the other hand, was only 15.88%.  In fact, gold had negative year-over-year returns in 16 of the last 35 years (from October to October)!  The S&P 500 TR had negative year-over-year returns only 5 times.

Food for Thought

A recent article by MarketWatch showed that if you had invested in gold in it's all time highs in the early 1980s, you wouldn't even be half way to breaking even when adjusted for inflation. 

Speculators who bought gold in 1980 are a classic example of buying at the peak. When the bubble bursts, they have a long way to fall.  Is it possible that speculators today could be setting themselves up for a similar downfall?

Conclusion

Gold is a risky asset class with poor relative returns. Though gold outpaced inflation over the past 35 years, it was a very volatile and inefficient hedge.  Investors today should carefully consider the lessons of the past. If you want to hedge against inflation, you are probably better off investing in a well-diversified portfolio of high quality stocks.