It's often touted that gold is a great, perhaps the best hedge against inflation. I'm not sure why this belief is so widespread among precious metal enthusiasts, but a quick look at the chart below, courtesy of Jeremy Siegel, Professor at the University of Pennsylvania and Senior Investment Strategy Advisor to Wisdom Tree Investments, should help put things in perspective.
This is a long-term chart looking back more than 200 years at the real, inflation adjusted returns of major asset classes.
The fact that gold shows a positive real return (0.6%) demonstrates that over the long run, gold is in fact a good hedge against inflation. But as you can see, stocks and bonds are much, much better. During that same time period, bonds have provided a 3.5% annual return in excess of the rate of inflation. Stocks, the best performing asset class over the last couple hundred years, provided a 6.7% real annual return.
So I guess the question is, why just keep up with inflation when you can beat the pants off of it?
Don't get me wrong, I understand the allure of gold for other purposes, especially in the short-term, but piling a majority of your net worth into gold is a questionable move. Let me rephrase that. If the only alternative is keeping your financial assets in cash, then putting them into gold makes sense as purchasing power is maintained and a small real return earned. But if you have the ability to include bonds and especially stocks in your portfolio, history suggests that you will be better rewarded for doing so.
The chart above has a logarithmic scale. What that means is that the Y-axis (vertical axis) increases exponentially. Notice that the difference between each "notch" on the vertical axis is not a fixed amount, as it would be in a linear chart. Instead, each notch increases by a factor of 10 as you move up the chart. This is going to make more sense in a minute, but what I'm getting at is that the outperformance of stocks is much stronger than is visually represented by the lines on the chart.
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First, take a quick look at this next chart. In case you are wondering whether the outperformance of stocks is distorted by the long time frame included in the chart above, this chart below covers a shorter and more recent time frame (1926-2010). As you can see stocks remain the vast outperformer in terms of real returns. But this chart is also logarithmic. A casual glance at the chart may give the impression that gold (yellow line) and bonds (red line) performed about a third as well as stocks. This is not the case.
Here is the same data as above using a linear chart. Now we can see the real outperformance of investing in stocks relative to bonds, bills, gold, and keeping that dollar in cash. Rather remarkable isn't it? Even through all the major ups and downs, bear markets and black swan events, stocks have been the best way to preserve and generate wealth over the past two hundred years. There is a good chance this will remain the case well into the future.
It's very easy to lose sight of this longer-term perspective when you become absorbed in the daily, weekly, and monthly fluctuations of stocks. In a financial environment that has become increasingly short-term oriented and filled with volatility, it's easy to discard the stock market as being casino-like, and want more safety. There is nothing wrong with that view and especially if short-term capital preservation is of utmost importance, reducing your exposure to volatile markets when valuations are near their upper ranges is a prudent decision.
But if your investment time horizon is longer, and we're all living remarkably longer these days, stocks need to remain part of your portfolio at least to some degree. Take stocks completely out of your portfolio, and you are removing the single largest wealth generator of all-time.
Another thing to consider is that the stock returns seen in the above charts include being in stocks 100% of the time. They include riding through each and every bear market and downturn in the markets. Now imagine how those returns would be enhanced if you had the wherewithal to reduce exposure during bear markets and reinvest during upturns. That of course is the goal here at DTL, in assessing the direction and health of the primary trend.
We can argue, and people will, about appropriate asset allocation strategies until the end of time. Perhaps the single most glaring takeaway from the charts above (especially the first one) is don't keep your savings in cash. Buy stocks, buy bonds, buy gold, real estate, whatever ... just buy something. But mostly ... buy stocks.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
