Gold as a Safe Haven
The need for safety is one of the most important human needs. The same goes for money – people need to feel that their money is safe. That’s why they look for a way to protect their capital against financial turmoil, and assets that protect this capital are called safe-havens. How does gold function as a safe-haven?
A safe-haven asset is an asset that is uncorrelated (weak safe-haven) or negatively correlated (strong safe-haven) with another asset or portfolio in times of market stress or turmoil. To put it another way, when the world and your portfolio are on fire, not everything you own loses value. Weak safe-havens do not lose value, and strong safe-havens are flourishing, thus protecting you against losses. So, a safe-haven protects investors during crises but not necessarily during normal times. Hence, a safe-haven asset is expected to retain its value or even increase in value during times of market turbulence when most asset prices decline.
It’s important to stress that a safe-haven is not bought to make additional profits. Safe-havens often do not pay any interest (e.g., gold, cash) or pay low interest on invested capital (US bonds). The main goal of a safe-haven is to protect you against downturns, systemic risks, and political turmoil. Thus, in the context of your portfolio, it’s used mostly as a portfolio diversifier which has no correlation or negative correlation with the rest of your portfolio.
A safe-haven can also protect you against financial system failure or political turmoil, when you can lose access to your accounts – bank or broker. If you have some precious metals or cash in physical form, you’re not yet stripped of your ability to pay your bills.
Gold as a Safe-Haven
Gold is commonly considered to be a safe-haven in times of financial or political uncertainty since it is not at risk of becoming worthless, unlike fiat currencies or other assets bearing credit risk. Gold works as a safe haven in a couple of ways.
Let’s start with the function of a safe haven during downturns. According to researchers Baur and Lucey (2010), gold is a hedge and a safe haven for stocks, but not for bonds – gold gains when stocks are falling, but not when bonds are falling (which makes sense, since lower bond prices equal higher interest rates). The authors also found that gold works as a safe haven only for a limited time, for around 15 trading days. This suggests that investors buy gold on days of extreme negative returns and sell it when market participants regain confidence and the volatility is lower.
Thanks to its safe-haven status, gold is used as a portfolio diversifier. Adding gold to your portfolio decreases your exposure to risk. However, adding gold to your portfolio does not mean higher returns – no boost there – but you can expect that unwanted events won’t hit your portfolio as hard.
Investors should remember that gold’s safe-haven features may change over time. For example, because the yellow metal becomes more popular as an investment to protect against equity market turmoil. Investors who hold significant amounts of gold in their portfolios may be forced to sell some or all of these holdings in times of equity market stress when they face borrowing or liquidity constraints in other portfolio holdings. This is what we saw in the aftermath of the Lehman Brothers' bankruptcy, and later again in the aftermath of the coronavirus pandemic, and the following stock market crash (see the chart below), due to the forced sales.
Generally, the perception of gold as a safe haven against crashes in any particular asset market is too limited. Gold is insurance against broader systemic tail risks. In other words, gold is a safe haven that protects investors during crises but not necessarily in normal times of high confidence in the fundamentals of the economy. However, gold is not a safe haven against any particular asset class. Rather, it is protection against systemic risks – an insurance against the current monetary system based on the fiat U.S. dollar.
Mentioned above, Baur and Lucey (2010) calculated that gold goes on average for two weeks during periods of strong downturns, but as we can see in the graph above, in some circumstances it can grow much longer when people are guided by the motive to run to a safe haven. When the coronavirus pandemic broke out, people were afraid that the financial system would collapse. The enormous amount of debt and the addiction to loose monetary policy were already scaring some investors before the pandemic. When firms were closing en masse, investors were expecting that stock markets around the globe would crash and central banks wouldn’t be able to do anything about it. So investors ran towards gold to protect themselves against systemic risk. Gold grew more than 30% during the year 2020.