What Causes Gold To Outperform Inflation By 700% - Or To Lose 80% Of Its Value? (A 50 Year Historical Analysis)

One of the most common reasons to buy gold is to use it as a stable store of value. This analysis uses 50 years of history to test that common belief, and finds it woefully lacking - for it misses the best parts of investing in gold.

The graph above will be developed, and we will show that gold is instead a more sophisticated (and desirable) investment than most people realize. When properly understood, gold can deliver unique advantages to knowledgeable investors, and it can be put to much better uses than just acting as a mere stable store of value.

As we will explore, the actual history of gold is that it can deliver real (inflation-adjusted) profits that are up to 7X greater than what a perfect inflation hedge would deliver. When we look at the times that this wide outperformance occurs, this means that gold can have an integral role in portfolio management in the modern era, and can "punch far above its weight" when compared to such inflation hedge alternatives as TIPS.

This analysis is the 16th chapter in a free book. The earlier chapters are of essential importance for achieving full understanding, and an overview of some key chapters is linked here.

Level One: The Theory Of Gold As Stable Money

The most popular perception of gold is that it acts as a stable store of value, and that it  will protect the purchasing power of savings against the ravages of inflation.

The need for such protection can be seen in the graph of inflation above, which shows average annual rates of inflation in the United States for the years 1962 through the first half of 2019. Any time the red line is above 0%, then the value of the dollar is falling. While the rates of inflation varied widely, on an annual average basis the dollar lost value every single year with the exception of a miniscule increase in value in the year 2009, during and in the aftermath of the Great Recession.

The cumulative impact of this steady destruction of the purchasing power of the dollar can be seen in the graph above. When compared to what it would buy in 1962, the dollar would only buy 50 cents by the year 1977. The purchasing power of the dollar would then drop in half again by the year 1989, and then in half again - down to a value of 12 cents on the dollar - by the year 2017. (If we go back to the 1933 when FDR took the U.S. off of the gold standard for domestic purposes, the paper dollar has lost 95% of its value since that time.)

The actual purchasing power of a vast amount of saver wealth has been steadily destroyed over the decades - and the theory behind owning gold it that it is supposed to keep that from happening. How has that worked in practice?

The graph above shows average annual gold prices from 1969 to the first half of 2019 - and gold has done very well indeed over those years. The average price of gold was $41 per ounce (on the London exchange) in the year 1969, and it was up to $1,307 dollars an ounce by the first half of 2019.

So the value of each dollar was way down, the number of dollars that each ounce of gold could buy was way up - did gold effectively protect the purchasing power of savings as it was supposed to?

Testing Gold As An Inflation Hedge

To test whether gold was an effective inflation hedge, we need to look at the value of gold over time in inflation-adjusted terms.

When we adjust the average annual price for an ounce of gold by the purchasing power of the dollar in each year, we get the graph above.

A hedge is something that protects the value of a financial position. A perfect inflation hedge that fully protects saver purchasing power would necessarily be a flat line in inflation-adjusted terms - an ounce of gold would always have the same real purchasing power, regardless of the rate of inflation that is experienced.

An example of such a perfect hedge is the blue line above. The average inflation-adjusted price of an ounce of gold between 1969 and 2018 was $840 an ounce (in 2018 dollars). If gold were acting as a perfect inflation hedge, then exactly maintaining purchasing power would mean sticking to the very stable and boring blue line above, with little or no annual variation.

However, when we look at the yellow line of actual historical gold prices on an inflation-adjusted basis - we get wild fluctuations instead of boring stability. The real purchasing power of gold soars, and then plunges, and then soars, and then plunges.

Let's break it apart, and see if we can get a better idea of what is happening.

The 1970s were a time of inflation, and on an annual average basis, the price of gold jumped from $36 an ounce in 1970, to $613 an ounce in 1980, which was a gain of about 1600% in ten years.

When we adjust the prices for inflation and put them in more current terms (2018 dollars), then the price of gold moved from $232 an ounce in 1970, up to $1,869 an ounce in 1980, which was a gain of about 700% in ten years.

Now, if gold were acting as a perfect inflation hedge or stable store of value, it should have started at an inflation-adjusted value of $232 an ounce, and ended at an inflation-adjusted value of $232 an ounce.

Instead, gold experienced a spectacular 8X increase in value in inflation-adjusted terms, creating the towering spike seen above. For gold investors - this movement was lucrative, and far more profitable than if gold were merely just keeping pace with inflation. (Just to be clear: going from 100% to 800% is an 8X increase but a gain of 700%, just as doubling (2X) the price of an investment produces a 100% gain.)

That said, there is a price that goes along with those extraordinary gains - and that is accepting that the overwhelming majority of the gains did not come from gold acting as a stable store of value, but quite the reverse. This then set the stage for a much more unpleasant era for gold investors.

After the peak annual average price of $613 an ounce in 1980 (not adjusting for inflation), the price of gold would trend downwards for the next 21 years, bottoming out at $271 an ounce in the year 2001.

That was a 56% loss on its own, but there was another problem as well. Inflation had not stopped, indeed some of the peak years for inflation in the modern era occurred during that time, with a 10.4% rate of inflation in 1981, and a 6.2% rate of inflation in 1982. By 2001 - the dollar had lost 53% of its purchasing power, relative to what it would have bought in 1980.

In order to just keep up with inflation, to act as an inflation hedge or stable store of value, gold should have more than doubled in price between 1980 and 2001 - but in practice it dropped in price by more than half.

When we combine the much fewer number of dollars that each ounce of gold could buy, with the much lower value of each of those dollars, then we get the graph above. In inflation-adjusted terms (2018 dollars), the value of gold fell from $1,869 an ounce in 1980 down to $384, which was a 79% decrease in purchasing power.

If someone had just held a dollar, their purchasing power would have been down to 44 cents by 2001. However, if they had held gold in order to protect themselves from inflation - then their purchasing power would have been down to 21 cents by 2001. Savers would have been much better off just holding on to their paper dollars.

What actual financial history shows us is that gold completely failed in its job of acting as a stable store of value for a period of a little more than two decades, losing almost 80% of its inflation-adjusted purchasing power.

Now, I'm not saying this to knock gold or to offend anyone. Indeed, the place that I am going is that gold is a far better investment than if it were just a mere stable store of value or perfect inflation hedge. Particularly from an overall portfolio perspective in these days of heavy-handed central banking interventions, including quantitative easing and many negative interest rates around the world - gold is a more sophisticated and powerful financial tool than most people realize.

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