a) Holding Gold Despite Inferiority:
Even though gold seemingly offers lower returns and higher volatility than stocks, there are still reasons why investors would hold gold:
Diversification: Holding gold provides diversification benefits. Since gold's returns are not perfectly correlated with stocks, it helps reduce portfolio volatility. In an economic downturn when stocks fall, gold often rises, acting as a hedge against losses.
This diversification effect can be visualized using a scatter plot:
Gold Returns
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Stock Returns ->
The above scatter plot shows that while both gold and stocks have positive returns, their movements are not perfectly aligned. This lack of perfect correlation allows gold to act as a buffer against stock market downturns.
Risk Tolerance: Some investors may have a lower risk tolerance and prefer the lower volatility of gold, even if it means sacrificing some potential returns.
Inflation Hedge: Gold is often considered a hedge against inflation, as its price tends to rise alongside inflation. This can be beneficial for investors concerned about protecting their purchasing power.
Safe Haven: In times of economic or political uncertainty, investors often flock to gold as a safe haven asset. This is because gold is seen as a tangible asset with intrinsic value, making it less vulnerable to market fluctuations.
b) Correlation Coefficient of 1:
If gold and stocks had a correlation coefficient of 1, meaning they move identically, holding gold for diversification loses its value. In this case, there's no advantage in holding gold alongside stocks as it wouldn't reduce risk.
Therefore, a correlation coefficient of 1 would significantly reduce the appeal of holding gold as an investment