Apr 14, 2010
Based on spot price data from January 1970 through February 2010, the average return on gold bullion was almost exactly the same as the S&P 500 at 88 basis points per month. Volatility was significantly greater for gold, but since gold prices tended to zig when equity prices zagged over this period, a portfolio composed of 80% stocks and 20% gold (rebalanced annually) had lower volatility than either of its component parts. Doesn't portfolio theory suggest that gold can make a useful contribution?

EFF/KRF: The answer to your question is "yes" — if you judge that the past average return on gold is the best estimate of its future expected return. We don't buy this, for two reasons. First, much of the stock of gold is in the form of jewelry and other goods that pay a "consumption dividend." This dividend increases the current price of gold and lowers its expected capital gain return. But an investor who holds gold bullion as a portfolio asset only expects to get the expected capital gain, which does not suffice to compensate for the risk of the asset. Second, if the capital gain return on gold is uncorrelated or even negatively correlated with the returns on other assets like stocks, then portfolio theory and its asset pricing offspring imply that the expected return on gold is low because of its role in reducing portfolio risk. Both arguments point to the conclusion that the past average return on gold probably overestimates its expected return.

To summarize, gold makes sense as a portfolio asset only for investors who also get the consumption dividend from gold, since this "dividend" lowers gold's expected capital gain. Thus, for investors who do not value the consumption dividend, the expected return on gold does not cover its risk as a portfolio asset, (which takes account of its value for portfolio diversification).

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.