Gold Rush

Over the last few years, the price of gold has soared. Spurred by advertisements on television, people have been predictably rushing to buy. It has also been a topic of interest for many of my clients. While I had planned to write this article for some time, I have procrastinated until now, because it seemed like such a daunting task.

For one thing, it’s hard to define. Is gold an investment? Is it money? It’s even more difficult to place a value on gold. Will prices continue to escalate? Is it too late to buy? Are we in the midst of a price bubble?

When I saw this video interview with Jack Bogle, the founder of The Vanguard Group, I was motivated to address these questions. Mr. Bogle has devoted his life to helping ordinary investors and has a special talent for making complex subjects easy to understand. When asked about his take on gold, Mr. Bogle responded plainly and emphatically that “gold is not an investment at all!”

How can this be? Surely, most of us wish we had gotten in a few years ago. With all the uncertainty in the economy, how can it not be a good investment? Mr. Bogle gives his reasoning in the video in his typically succinct fashion. That said, let me also offer my opinion as well.

Gold is an investment, but it is just a speculative venture, rather than a fundamental investment. It doesn’t have much intrinsic value because it doesn’t produce any income. Sure, it’s great in jewelry and has other uses, but let’s fact it, that’s not what has been driving the price up.

If you purchase an ounce of gold, in a few years it will be worth about the same amount unless investor sentiment changes. The price will rise in the future only if someone is willing to pay more, but there is no essential reason that they should. This means that the price is determined by speculation, rather than fundamental investment principles. With an expected stream of income, you can expect a probable return on your investment. Without the expectation of income, how do you know someone will pay more for it? They might pay more, but only if they think another speculator will pay even more in the future.

During the time that you hold the ounce of gold, the cost of other goods and services will also inevitably rise and your gold might not even be able to buy the same amount of other things. Even though there was a steady erosion of purchasing power due to inflation, the price of gold was around $400 an ounce for about twenty-five years between 1980 and 2005. This means that gold lost value in real terms during a pretty long period of time.

To be fair, gold values have caught up during the last five years with the surge in price. For this reason, some people own gold as a hedge against inflation, even though it might not track closely with regular cost of living increases. Unfortunately, you would have enjoyed this price increase benefit only if you were very patient and decided to wait out the dry spells or were prescient to purchase gold a few years ago, before the prices escalated. Not too many people fall into either category.

Of course, people have historically been willing to pay handsomely for gold at times. Gold also tends to hold its value in real terms. This means that you can hope and expect it to keep up with the costs of living, but that’s about it. Gold has only earned about the rate of inflation over the long term. Unlike stocks and bonds, which pay dividends and interest, there has been no additional investment return above inflation. For an asset to be a true investment, I think you should expect to have greater wealth in terms of purchasing power compared to where you started.

One particular aspect of gold that I have trouble accepting is that investment risk and return does not follow the usual relationship. On a standalone basis gold is more volatile than stocks yet produces a lower return. This is not a great combination. Over a short period of time it can produce extraordinary returns, but it can also suffer rapid losses.

As part of a diversified portfolio of assets, this volatility can work in your favor. Non-correlated or negatively correlated assets, which are those that run counter to other assets, can reduce risk by dampening the overall portfolio volatility. With a smoother ride, a portfolio can earn a slightly higher return than a portfolio that fluctuates dramatically. Therefore, even though gold might not earn an inflation adjusted return on a standalone basis, it can help the overall portfolio return. The question is whether or not the advantages outweigh the higher holding costs and lack of income compared to traditional stock and bond funds.

The asset certainly looks attractive in hindsight, but keep in mind that gold prices can fall as quickly as they rose. For this reason, most financial advisors recommend it only for a small percentage of a portfolio. This being the case, is it worth the trouble? If you are only going to have 5% or 10% or less of the portfolio in gold, it's not really going to make or break your performance.

I believe gold is really a form of money, rather than a true investment. The U.S. dollar is the reserve currency around the world and is also generally considered the safest form of money. Gold is second in popularity and confidence. When confidence in the U.S. dollar drops as it has recently, investors shift to gold as a substitute. If the dollar strengthens, we could see the price of gold decline rapidly. Therefore, it’s largely a play against the dollar – which again is speculation.

I’ve also never understood the rationale for the former “gold standard” to which some people would like to return. Why should gold determine wealth? Let’s suppose that some small country in Eastern Europe – we’ll call it Verilukystan – suddenly discovers vast gold deposits under its soil worth one trillion dollars. Should Verilukystan be considered wealthier than Germany or France? Personally, I think wealth is best measured by what a country can produce in goods and services, rather than by the amount of a yellow metallic material in its vaults or mines.

This brings up the issue of valuation. How do you know what is the correct price to pay for something that does not have a predicable cash flow? Are we in the midst of a gold bubble, as many people think?

Currently, I suspect that we are in a bubble, but we might not really know for a few years. After witnessing the bursting of the technology stock bubble and the real estate bubble over the last decade, I’m not eager to see people get hurt again. Even if you think it is a bubble, it’s impossible to know when it will burst. Speculative periods can extend for many years. I think gold prices are likely to continue to rise further for a few more years because of the uncertainly over the fiscal and monetary policies of the U.S. and the European countries. Even so, I’m not convinced that these problems won’t be resolved. If confidence returns in the U.S. dollar, we could witness a rush out of gold investments.

At this time, I have not been pursued to include gold exposure in the portfolios that I design. If a client requests to include it, I would want it to be a policy decision as part of a long-term strategy, not a reaction to recent performance. As an investment advisor, I think it is important to keep an open mind. If adding gold makes a person more comfortable and they feel good by having gold in their portfolio, I am not opposed to it.

In my judgment, gold is best suited for speculators, but it could also be used by long-term investors who place a very high premium on protecting the downside (at the expense of growth). It’s up to each investor to determine if investing in gold makes sense for them. They just need to try to determine if they are being wise “prospectors” or just getting caught up in the current “gold rush” trend.