Is gold a safe-haven or a hedge?

The article below addresses the following questions and comes to some enlightening conclusions.

• Is gold a safe-haven or a hedge, and what is the difference between them?
• What is gold supposed to be a safe-haven or a hedge in relation to?
• Does gold protect investors from a stock market crash, bond market volatility, inflation, or a systemic crisis?
• Do the safe-haven properties of gold depend on the country and the time horizon?

Read on!

The above comments, and those below, have been edited by Lorimer Wilson, editor of munKNEE.com (Your Key to Making Money!) and the FREE Market Intelligence Report newsletter (see sample here – register here) for the sake of clarity ([ ]) and brevity (…) to provide a fast and easy read. The contents of this post have been excerpted from an article* by Arkadiusz Sieron/Przemyslaw Radomski (sunshineprofits.com)  originally entitled Is Gold a Safe Haven? ‏ and which can be read in its unabridged format  HERE. (This paragraph must be included in any article re-posting to avoid copyright infringement.)

Let’s start with the definitions:

• A safe-haven is an asset that is uncorrelated or negatively correlated with another asset or portfolio in times of market stress or turmoil.
• A hedge is an asset that is uncorrelated or negatively correlated with another asset or portfolio on average.

Hence, a safe-haven protects investors during crises, unlike a hedge, which protects them in normal times, but not necessarily during turmoil.

According to Baur and Lucey (2010), gold is a hedge and a safe-haven:

• for stocks,
• but not for bonds but only
• for around 15 trading days. This suggests that investors buy gold on days of extreme negative returns and sell it when market participants regain confidence, and volatility is lower.

Baur and McDermott (2009), using data from 1979 to 2009, showed that gold is both a safe-haven and a hedge for:

• major European equity markets and the U.S. but
• not for Australia, Canada, Japan or major emerging markets such as the BRIC countries (investors suffering losses in emerging stock markets turn to developed markets rather than to purchasing gold).

Although most economists agree that gold is a safe-haven, Baur and Glover (2012) remind investors that:

• the safe-haven features may change over time as gold gets more popular as an investment to protect against equity market. This is because investors who hold significant amounts of gold in their portfolios may be forced to sell some or all of these holdings in times of equity market stress when they face borrowing or liquidity constraints in other portfolio holdings.

The above is an interesting point, especially when gold prices initially fell after Lehman Brothers’ bankruptcy due to forced sales (see chart 1), but we believe that the perception of gold as a safe-haven against crashes in any particular asset market is too limited.

Gold is an insurance against broader systemic tail risks. The economic function of insurance is not to generate huge profits during normal times, but rather to:

• protect investors’ wealth against unlikely but serious events and
• protect wealth against tail risks.

From this perspective, it should be clear why gold has no yield. Has insurance any yield? No, actually you have to pay premiums for being insured. The same applies to gold

Tail risks…arise when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. To simplify, there are very unlikely events which entail very serious consequences. The best example is the last financial crisis. As you can see in chart 1 below, stocks (and other standard financial assets) drastically fell after the Lehman bankruptcy and suffered huge losses in 2008, while gold ended that year with a modest gain.

Chart 1: Gold prices (yellow line, right scale) and S&P500 Index (blue line, left scale) from 2007 to 2009

Why are there tail risks and why does gold protects against them?

It is in the very nature of our inherently unstable monetary system with its fractional reserve banking system, paper currencies and excessive credit, which is based only on faith. Gold used to be money for thousands of years, whereas our fiat money experiment has been here only since 1971. Thus, when this faith decreases, especially in the U.S. dollar, the unofficial world currency, gold prices rises.

Contrary to paper currencies, gold is a real commodity which cannot be printed and has a certain use value, which sets a bottom for its prices – this explains why there is demand for it in times of distrust in the U.S. dollar system.

You can think of gold as an insurance or backup in case of the collapse of the fiat money economy with the greenback as the world reserve currency. That way, the price of gold reflects the tail risks connected to the unstable monetary system.

Indeed, portfolios including gold tended to perform better during most financial stresses, according to the World Gold Council’s report.

• Gold prices were increasing during the 70s, the time of high inflation and uncertainty over the new global monetary system, and in the 2000s, when over-indebtedness in the U.S. shook trust in the dollar-dominated system.
• Contrarily, gold prices were falling in the 80s and the 90s, when Volcker renewed the trust in the greenback, and after September 2011, when the extraordinary measures of central banks restored the confidence and reduced the bidding for tail risk insurance.

Conclusion

The key takeaway is that:

1. Gold is a safe-haven
   • which protects investors during crises, but not necessarily in normal times of high confidence in the fundamentals of the economy and
   • which does not protect against any particular asset class.
2. Gold is protection against systemic risks
   • an insurance against a current monetary system based on the fiat U.S. dollar.

*http://www.24hgold.com/english/news-gold-silver-is-gold-a-safe-haven-.aspx

Related Articles from the munKNEE Vault:

1. Gold – Is It A Commodity, A Currency, Neither or Both?