In a world increasingly focused on the short term, five years can seem like an eternity. How many among us would stick with an investment that has gone nowhere for five years? That is precisely the question Gold investors are faced with today, with a return of -7.4% over the past five years.

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The case for buying Gold five years ago was seemingly obvious. The Federal Reserve was embarking on a second round of quantitative easing and continuation of 0% interest rates. This was supposed to lead to higher inflation, a collapse in the U.S. Dollar, and increased demand for the “other” currency: Gold.

Fast forward five years and we have seen continued central bank easing, not only in the U.S. but across the globe. While we did see inflation in housing and stocks prices, what we did not see was a collapse in the Dollar or a spike in reported inflation. We also did not see an increase in the demand for Gold.

The past five years have not been a straight line, though. Gold prices initially surged higher in 2011 and money flowed in as investors chased returns. For a brief period of time the SPDR Gold Shares ETF (GLD) stood as the largest ETF in the world. Since then, Gold prices have fallen (-36%) and assets in GLD have fallen more, declining over 65% from their 2011 peak.

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So the answer to the above question about how many of us would stick with an asset that has declined over the past five years is … not many.

Still, there remains $27 billion of assets in the Gold ETF, not a small sum. Those sticking with the yellow metal today argue that Gold is not just an “inflation hedge,” but also acts as an insurance policy of sorts. It is supposed to provide an uncorrelated alternative to stocks that proves valuable during times of stress.

Fair enough. There has been no stress to speak of in recent years and thus no need for any uncorrelated exposure or diversification in hindsight. But eventually we will enter another volatile period in equities where gold will prove valuable – or so goes the argument.

Let’s examine this thesis, looking at the period from 1976 through today.

First, Gold is indeed uncorrelated to stocks, with a monthly correlation of .02 to the S&P 500. Second, it has acted as a hedge on average with a -7.7% down capture to the S&P 500, meaning it tends to rise when the S&P 500 falls. During months in which the S&P 500 has finished lower, Gold has risen 53% of the time.

Lastly, introducing Gold into a stock portfolio has also improved risk-adjusted returns (return/volatility). A 60/40 portfolio of Stocks and Gold slightly underperforms Stocks alone (9.5% vs. 10.7%) but does so with lower volatility (-11.9% vs. 14.9%) and lower drawdowns (-29.9% vs. -50.9%) than an all-stock portfolio (see Table 1).

Based on these stats, a reasonable case can be made that Gold can add value to an all-stock portfolio. But this conclusion is one made only in isolation, failing to consider other competing investments. Gold is not the only asset class with a low correlation to equities that can mitigate volatility in a portfolio.

There are also Bonds. Since 1976, the Barclays Aggregate Bond Index (AGG) has a correlation of .22 with the S&P 500 and the Merrill Lynch 15+  Year Treasury Index has a correlation of .07. Both bond indices have a down capture ratio that is more negative than Gold (-10.0% and -15.9%) with a higher percentage of positive returns during down months for the S&P 500 (61% and 55%). They also tend to perform better during up months for the S&P 500, with up capture ratios of 22% and 21% versus 16% for Gold.

An additional factor favoring Bonds over Gold is their lower volatility. A portfolio of Stocks and Bonds produces a significantly higher risk-adjusted return than a portfolio of Stocks and Gold (see Return/Vol in Table 3 below). Adding Gold to a portfolio of Stocks and Bonds seems to add little additional benefit other than a lower correlation profile to the S&P 500.

Gold, What is it Good For?

In the past forty years, Bonds have been the better alternative than Gold for investors seeking to minimize drawdowns and lower volatility in their portfolios. Bonds also throw off an income stream while Gold yields nothing. Does that mean Gold is good for absolutely nothing, having no place in a portfolio?

No. The future is not the past and anything could happen in the next five years.

Should we see high inflation and rising interest rates as we saw during the 1970’s, Gold would likely prove beneficial in a portfolio. If the U.S. Dollar were to experience a sharp decline, one would also expect Gold to perform well.

Handicapping these scenarios is not an easy task and I certainly wouldn’t recommend trying. The real questions for Gold investors are about staying power, discipline, and asset allocation.

1) Staying Power: How long are you willing to wait for Gold to prove its worth? Gold is down over the past five years which already seems like an eternity. Would you be willing to sit in Gold for twenty-seven years with flat returns as we saw from the peak in 1980 through 2007? Not likely.

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2) Discipline: Gold is prone to sharp spikes higher and dramatic moves lower. Do you have the discipline to resist buying Gold after a spike and selling Gold after a crash? This is true for any asset class but given the higher volatility of Gold it is a particularly important question.

3) Asset Allocation: Assuming you have staying power and discipline, what is the appropriate sizing for Gold in a portfolio?

There is no easy answer to this question and really comes down to 1) whether you view Gold as a better diversifier and equity hedge than Bonds and 2) what your expected returns are for Gold versus Stocks and Bonds.

As outlined above, Gold hasn’t been a better hedge or diversifier (on average) than Bonds in past forty years. On the second question, there is a strong case that can be made that equity and fixed income returns will be below average in the coming years considering today’s high valuations and low bond yields. This should increase the odds of Gold holding its own as compared to the early 1980’s when equity valuations were low and bond yields were high. That said, even if Gold performs well in the next five years, it’s likely to be a volatile ride. Which is why for most investors staying power, discipline, and sizing may actually be more critical than returns.