Whenever an asset class experiences a large price swing, whether up or down, people naturally try to understand what the causes have been and whether or not the asset class is currently worth buying or the reverse.  Indeed, since the beginning of 2013 we’ve seen the price of gold drop by 25%.  Gold is now on track to be the worst performing asset class of the year.  The question:  is it still a good investment or not?

As an investible asset class, gold is unusual in that it is largely non-productive.  It does not generate interest, nor is the majority of above-ground gold used as a raw material.  Much of it is held as jewelry or as bullion for speculation.  As a result, its price is mainly affected by changes in sentiment (demand), rather than changes in annual production (supply).  These factors make it extremely difficult to estimate its value at any point in time.

Given that, why would anyone hold gold in an investment portfolio?  There are a number of situations in which gold has historically performed well.

• A weakening U.S. dollar.  When the value of the dollar falls against other currencies, the price of gold in dollars increases, and investors are more inclined to hold gold.
• Inflation.  Gold has historically been an excellent hedge against inflation, because its price tends to rise when the cost of living increases. Since World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979 and 1980. During those years, the average real return on the Dow Jones Industrial Average was -12.33%, compared to 130.4% for gold.
• Geopolitical uncertainty.  Gold retains its value not only in times of financial uncertainty, but in times of geopolitical uncertainty. Investors have has a tendency to flee to the relative safety of gold and other hard assets such as real estate when world tensions rise. Its price often rises the most when confidence in governments is low.
• Supply constraints.  Much of the supply of gold in the market since the 1990s has come from sales of gold bullion from the vaults of global central banks.  Production of new gold from mines over the same period has been declining.  As a general economic rule, reduction in the supply of an asset increases its prices.
• Increasing demand.  With the decades-long economic growth in countries like India & China, where gold is highly valued from a cultural standpoint, demand has soared.  At the same time, demand for gold has also grown among investors.  One of the world’s largest holders of gold bullion is the SPDR Gold Trust, an ETF created to make it easy for investors to own gold.
• Portfolio diversification.  The key to diversification is finding investments that are not closely correlated to one another.  When you combine such investments, you not only reduce overall portfolio volatility and risk but in many cases actually improve returns.  Although correlations do change over time, gold historically has had a lower correlation to stocks and bonds than do many other asset classes.

The bottom line is that, despite the difficulty in valuing it, many investors continue to keep some amount of gold in their portfolios.  Its price tends to increase in response to events that cause the value of paper investments, such as stocks and bonds, to decline.  Throughout the years, it has served as a hedge against inflation and the erosion of major currencies.  In spite of its performance in 2013, it should remain under consideration for inclusion in most investment portfolios, if for no other reason than as a risk diversifier.