With global stock markets entering into uncharted territory, a less commonly discussed asset class has caught the attention of many investors: gold.

If you are new to this asset class, or simply looking to better understand how gold works as an investment, this introduction to gold should serve as useful overview. In the article, we’ll explore three key aspects of gold investing:

• the factors that drive the price of gold,
• gold’s role in portfolio construction, and
• the different ways investors can gain exposure.

The growing popularity of gold

Companies involved in the production of gold make up a significant part of the Canadian stock market in 2020. This is because many consider gold to possess many desirable properties as an investment, including: as a store of value, safe haven asset, currency, commodity and hedge against traditional asset classes like equities and fixed income.

Gold prices have reached an all-time high in 2020 

Source: Bloomberg as of October 31, 2020. Gold prices in U.S. dollars.

There are two main ways to gain exposure to gold:

• Buy physical “gold bullion” directly. Or buy an investment vehicle which tracks the gold price.
• Buy the stock of gold companies on the open market.

Both methods offer meaningful exposure to the properties of gold, highlighted below. But there are differences worth consideration.

Interest in gold often increases whenever there is an economic crisis that causes a broad selloff across many different types of investments. Gold is often viewed as a way to manage risk during severe periods of market uncertainty. But it is important to understand the fundamentals that impact the price of gold.

Gold prices are driven by:

Economic crisis

One of the factors affecting gold prices is economic crisis. Generally, when investors start becoming fearful, they turn to ‘real assets’ like gold which are perceived to be a more stable and safe store of value. Gold is considered a real asset as it can be physically owned. Another example of a real asset is real estate.

Gold often performs well during an economic crisis

Asset class performance during the Global Financial Crisis

Source: Morningstar Direct, returns from December 31, 2007 to June 30, 2009. Gold represented by the S&P GSCI Gold Spot Index. Gold equities represented by the S&P/TSX Global Gold Index. Canadian equities represented by the S&P/TSX Composite Total Return Index. U.S. equities represented by the S&P 500 Total Return Index. Global equities represented by the MSCI World Net Return Index. Canadian bonds represented by the FTSE Universe Canada Bond Index. Returns in Canadian dollars.

A depreciating U.S. dollar

The U.S. dollar is one of the largest contributing factors in the price movements of gold. The relationship between gold and the U.S. dollar is inverse. This means the gold price tends to rise during periods of a weak or weakening U.S. dollar. This is because gold is priced in U.S. dollars. When other currencies (like the Canadian dollar) appreciate, it becomes cheaper to buy gold, thus increasing demand from purchasers outside of the United States.

A weak or weakening U.S. dollar has historically supported gold prices

Source: Bloomberg, as of October 31, 2020. U.S. dollar represented by the U.S. trade weighted dollar index. Gold prices in U.S. dollars.n bonds represented by the FTSE Universe Canada Bond Index. Returns in Canadian dollars.

Gold is often cited as an effective safeguard against inflation. In other words, it can help preserve purchasing power over prolonged periods of time. Unlike cash, which loses its purchasing power every year as inflation increases, the gold price tends to be resilient. This can been seen in the chart below, which shows how the price of bread per ounce of gold has steadily declined over time, whereas the opposite is true in dollar terms.

Over the long term, gold has helped preserve purchasing power vs. the Canadian dollar

Source: Bloomberg, Statistics Canada. Data as of December 31, 2019.

Gold prices tend to exhibit a negative correlation with real interest rates, meaning they move in opposite directions. This is because as rates fall, holding assets like bonds becomes less attractive as they offer lower returns for investors. This increases the demand for other investments.

Generally, declining real interest rates coincides with an economic crisis. Therefore, this is often a difficult period for equity markets too. With both equities and fixed income becoming less attractive, these periods tend to be strong for alternative assets like gold.

Gold tends to exhibit a negative correlation with real interest rates

Source: Bloomberg, as of September 30, 2020. Real interest rates calculated using U.S. 30 year government bond yields minus inflation. Gold price in U.S. dollars.

Gold in an investment portfolio

In isolation, the gold price and gold stocks exhibit more volatility than bonds and other stocks. However, historically gold and gold equities have tended to move in an opposite direction to these types of investments. This can be seen by the 10-year correlation matrix. As you can see, gold and gold equities exhibit almost no correlation to equities. For this reason, gold and gold equities can be used to help diversify an investment portfolio. They can provide stability when economic conditions deteriorate and traditional asset classes falter.

Gold exhibits a low correlation with traditional investments

Source: Morningstar Direct, 10-year correlations based on monthly returns in Canadian dollars as of October 31, 2020. Gold represented by the S&P GSCI Gold Spot Index. Gold equities represented by the S&P/TSX Global Gold Index. Canadian equities represented by the S&P/TSX Composite Total Return Index. U.S. equities represented by the S&P 500 Total Return Index. Global equities represented by the MSCI World Net Return Index. Global bonds represented by the FTSE WGBI Index. Canadian bonds represented by the FTSE Universe Canada Bond Index.

Over the long term, gold can bolster the returns of a traditional portfolio composed of equities and fixed income. Perhaps most importantly, an allocation to gold can help during periods when a traditional balanced portfolio delivers negative returns. This can be seen by the chart below.

¹Hypothetical Balanced Portfolio reflects backtested performance data using index returns, gross of fees. 2Hypothetical Balanced Portfolio and gold returns reflect backtested performance data using index returns, gross of fees. See the disclaimer for more information about the backtested performance data. 3Gold equities reflect RBC Global Precious Metals Fund Source: BlackRock, Bloomberg as of December 31, 2019.

Due to the relative expansion of gold equities in the S&P/TSX Composite Index, many investors have some exposure to gold through the portion of Canadian equities they hold. However, for those who are looking beyond that for an effective diversifying option in their portfolio, adding a dedicated gold sleeve is an option worth exploring. Over time, gold has proven to provide stability, downside risk protection and capital appreciation when other types of investments are under pressure.