A volatility-based approach to gold as a safe haven: can it explain the abnormalities in gold returns during periods of extreme financial adversity?

In this paper, the authors provide an explanation of the abnormal behavior of gold returns between the 1^st of January 2008 and the 31^st of December 2013. The authors suggest a behavioral finance foundation to the fact that gold returns exceed those of a wide range of other assets over this period. The approach rests on the safe haven (SH) motif for flights to gold during heavy financial stress periods. The prevailing Baur-Lucey-McDermott paradigm on gold as a SH is shown to be insufficient, as it ignores the roles of volatility and risk preferences. The auhors suggest a formal SH definition, recovering those elements from behavioral finance. Contrary to the previous paradigm, the approach is data-consistent, in the sample period. The authors find that gold is a SH for all stock markets considered, some exchange rates, and even Euro Area sovereign bonds (including German bunds). They estimate the SH risk premium in all cases. The authors find that investors perceive the distinction between good and bad volatility, and that they do not ask for excess returns when gold volatility is high for SH reasons. This is consistent with the literature on the low frequency of idiosyncratic shocks in the gold market. Furthermore, the authors find evidence that, in a period of high financial uncertainty, fund managers building portfolios consisting only of gold might be acting rationally, contrary to the finance common sense for normal periods. In fact, in the sample period, gold is even strictly dominant in mean-variance terms, when compared to equity.

Keywords: safe haven, gold, euro debt crisis, risk preferences, fund management.
JEL Classification: C22, C58, G01, G11, G15