The global financial and economic crisis and the corresponding government policy reactions have led to an increased focus on gold as an investment. The precious metal is one of the “alternatives” to stocks and bonds that receives much more attention when economic prospects appear most uncertain.
Gold is often referred to as a “portfolio diversifier” – offering some form of protection against economic harm. In fact, gold is considered its own investment category by some who believe its characteristics as a currency can help provide stability in the face of extreme events such as a global financial crisis, a geopolitical catastrophe or an outbreak of rapid inflation.
Though gold may be presented as a stable refuge from economic disaster, the data tells a different story. Historically gold has experienced a standard deviation (volatility of price) higher than that of the S&P 500 stock index while delivering a substantially lower return. For instance, after setting a record high of $850 per ounce in January 1980, the price of gold plummeted by almost 44% in less than two months. It wasn’t until January 2008, 28 years later, that gold again reached a price of $850 per ounce. Thus, over nearly three decades, gold underperformed inflation by an incredible 175%.
Despite the data, financial principles should ultimately guide any investment decision – this means having a fundamental rationale rooted in economic logic and portfolio theory. Principles of modern finance suggest the primary components of a diversified portfolio should have an expected return. And only projected earnings can generate an expected return. Since gold neither pays a dividend nor generates cash flow, there is no basis for expecting a future return. It is this fact that led widely respected Vanguard founder John Bogle to recently state:
“Commodities don’t belong in anybody’s portfolio at any time for any reason. It is a total speculation. You can make money by speculating, and someone else will lose. Look at gold – with no internal rate of return, it has not matched Treasury Bill performance. It is not investing, it is a gamble.”
Uncertainty and risk can be frightening, but it’s a fact of life investors accept. Modern finance teaches us that the risks most worth taking are those that carry an expected return. With stocks and bonds, investors put their money to work in the capital economy. These investments help power enterprises that generate growth and productivity – this is what earns expected return. Simple commodities like gold don’t create economic growth. As Bogle indicates, “investing” in gold is really just speculating: you hope the price will go up, but have no real reason to expect it to.
And unlike other commodities such as oil, gold is not consumed. Even when it is used in products like jewelry, it is recoverable and thus maintains its value as the gold that went into it. Consequently, the total supply of gold is increasing over time as additional gold is mined.
The price of gold is primarily driven by investor psychology. And given the uncertain environment, gold is being heavily marketed as an investment again this year. For better or worse, with the advent of exchange traded funds tracking gold, it has become much easier for individuals to invest (often chasing performance) in the precious commodity. While there is no denying that gold has periodically delivered very attractive returns, investors must recognize that it has also experienced tremendous price declines resulting in flat or even negative returns for periods of twenty years or more.
The principles of modern finance provide a framework for distinguishing investing from speculating. They clarify our motives so that we can make informed, rational decisions and adhere to the fundamentals of long-term investing. There’s nothing wrong with placing a small percentage of assets in gold or other commodities, but having a clear understanding of what you’re doing and why is the key to prudent investing.