Embracing gold’s volatility

Dear Investor,

Gold and silver prices have rallied sharply in the last few trading days, with the two precious metals back trading above USD $1700 oz (gold) and USD $21oz (silver). In Australian dollar terms, the news is even better, with gold for example now back above AUD $2,650oz.
 
This price strength, which represents a volatile move to the upside, will no doubt have many bullion investors hoping we’ve now seen the end of the corrective period the two precious metals have endured in recent months.
 
In our latest blog, we discuss the volatility of gold in some detail, looking at

• How gold’s volatility is driven by sharp upside price movements

• The importance of gold’s correlation with equity markets

• Gold’s lack of credit risk, and why drawdowns are never permanent

Combined, these factors help explain why, from our perspective at least, gold’s volatility, rather than being something for investors to fear, can be something to embrace.
 
This is especially true after the precious metal has gone through corrections like it has since early 2022.

Gold’s volatility is driven by sharp upside price moves

While investors tend to think of volatility in terms of asset prices falling (indeed, news articles will often talk of volatile days with the market falling however many per-cent), the reality is that volatility works in both directions.
 
Rapid rises in price are volatile moves too – it’s just that as a general rule, investors happen to like that kind of volatility.
 
In this regard, gold has an advantage over share markets, because gold’s volatility is more a function of sharp upside movements in price, relative to downside movements in price.
 
To visualise this, consider the table below, which shows the average return in the largest five, ten, twenty-five and fifty monthly performance moves for both shares and gold (both in USD and AUD) dating back to 1971.
 
As a way of explaining the data, if for example an asset had a largest ever monthly move of +12%, and its second largest monthly move was -10%, then the average of those two moves would be +1%.

Average returns from largest monthly moves in stocks and gold 1971 to 2022

Source: ABC Bullion, London Bullion Market Association, RBA, Yahoo finance

As you can see, the average return for the share market in the top 5 and 10 months it has had its largest moves in either direction are negative, meaning there is more of a chance to get a large and unwelcome downside surprise in share markets, relative to an upside surprise.
 
For gold it’s the complete opposite, with the precious metal, when priced in either US dollars or Australian dollars delivering extremely positive average returns in the months that it moves fastest.

Gold’s correlation with equities

Statistical analysis demonstrates that gold has historically been negatively correlated with a falling equity market, providing protection when needed most. It has also historically been positively correlated to rising equity markets, contributing to overall portfolio growth in the good times.
 
Given this relationship, an investor that holds both gold and equities will almost certainly see lower overall portfolio volatility than a pure equity market investor, even though gold itself is volatile.
 
This can be seen in the table below, which also highlights the fact golds best year performance wise is much better than equities best year, while its worst year saw a smaller correction.

Table: Investment characteristics for US equities, gold, and 50/50 portfolio 1971 to 2022

Source: ABC Bullion, London Bullion Market Association, Yahoo finance

The table also highlights how much smoother the blended portfolio is compared to the individual assets.

Gold’s drawdowns are never permanent

Because gold is not an investment like shares in a company, and has no credit risk, there is no chance it can default, or go bankrupt. As a result, while it’s volatile, and can suffer drawdowns, those drawdowns inevitably resolve themselves over time.
 
As an investor, you therefore have some comfort that any drawdown in the gold price is simply part of the market cycle (gold is not immune to bull and bear markets), rather than a potential message that the drawdown will be permanent.  
 
Investments in individual companies offer no such comfort. While a drawdown in the price of a particular stock may just be part of the market cycle and an overall stock market sell off, it could also be a warning sign that the company in question is facing serious problems and could be headed toward bankruptcy.
 
For example, consider the chart below, which displays the share prices of Bear Stearns, and Lehman Brothers, two of the highest profile failures from the Global Financial Crisis.

The share price bust for both companies that is evident in the chart occurred alongside a wider drawdown in equity markets that would ultimately see the S&P 500 lose more than 50% at its lowest ebb.
 
Bear Sterns investors at least got some money back, with JP Morgan buying the company for $10 a share, some 90% below its all-time high. Lehman investors were not so lucky, suffering a permanent loss of capital as the company filed for bankruptcy in September 2008.
 
Gold prices can be volatile in the same way Lehman stock was. But investors in gold don’t  face the risk that Lehman shareholders did.

Takeaway for investors

The data in this article highlights why gold’s volatility, as uncomfortable as it may be at certain times, need not be of any real concern for long-term investors with a strategic allocation to the precious metal.
 
The drawdowns that it occasionally suffers are inevitably resolved, as gold has no credit risk, while it’s correlation with equity markets means that for most investors that own both gold and equities, their overall portfolio will be less volatile than the two assets are on a standalone basis.
 
Finally, gold’s volatility is far more heavily influenced by sharp upside movements in price, which is something we are yet to hear an investor complain about even once in our 25 years in financial markets.

Warm regards,
The ABC Bullion Team

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