Are the Benefits of Gold Really “As Advertised”?

If you flip on talk radio in your car for any extended period of time these days, it’s hard to miss those commercials lauding the benefits of owning gold.  Essentially the message of many of these commercials is the same:  Basically, we’re headed for hyper-inflation and the best thing to protect you from inflation is gold!  Oh and I forgot the other part of their message:  “You should be buying it from us!!!!”.  But is gold really a reliable inflation hedge and should it constitute a large portion of your investments?  (Quick aside: Before discussing my views on the advantages and disadvantages of gold in a portfolio you’ll probably guess that I’m not a big fan of any “investment” that is pushed on the radio.  It’s kind of like those 1-800 numbers for “insider tips” on betting NFL games.  I hear those guys and wonder: “If they know so much about betting NFL games, why not just make a living betting themselves?” Why are these guys so generous with their “insider knowledge”?  I think we all know the answer to that one.)

Now, before we get into the discussion on gold, I think it’s worthwhile to first consider where any investment fits in the context of an asset allocation strategy.  Essentially, I believe every asset class has a “job” to do in a portfolio.  These “jobs” include increasing in value, providing cash flow and minimizing volatility across a variety of economic scenarios.  The idea is that over the long term, this mix of assets provides the right balance of risk and return in line with investors’ goals. So when we turn to gold, some folks think of it (or other precious metals) as an integral part of their portfolio as it is commonly perceived gold’s “job” is to provide a hedge against rampant inflation or other chaotic scenarios.  Now I won’t claim to have a crystal ball as to what inflation will look like in the coming years, but I think the relevant question is this:  Is gold really a reliable inflation hedge?  The short answer:  Not according to its historical performance.

Let’s look at the time period from the 1980 to 2000 when inflation was much more pronounced than it is today.  To illustrate, $10,000 for a car in 1980 would cost you almost $21,000 in 2000.  That’s an annualized inflation rate of about 3.75% in the 20 year period.  What did the price of an ounce gold do during that period?  Did it more than double?  Nope- it actually declined from over $615 to about $279 – an annualized decline of 3.9%.  So if you had taken that $10,000 in 1980 and bought gold to hold for 20 years, you would have the tidy sum of $4,538 to buy that car in the year 2000.  That will certainly crimp your style.

Of course there are many time periods when gold rises quickly like 2005 to the 2012 when gold went from $445 to about $1,700 an ounce, a 21% annualized increase!  What was inflation during this time?  A much more modest 2.36%.  So if in 2005, you made the right call on inflation backing down and sold all of your gold, you lose.  Again- the question is did gold prices closely correspond with inflation?  Clearly- no. Some might argue the recent price increase was driven by fear for a collapse in the financial system and that could be valid.  But the point is there are time periods when gold does go up faster than inflation and some time periods when it does not.  That to me, is not a reliable hedging instrument.

Putting the hedging “job” aside another question comes up:  Is gold a good long term investment?  As you may suspect by now, over the long term, the answer is no. As noted in “Common Sense on Mutual Funds” by John Bogle, a book I highly recommend to all investors, the real return of gold from 1802 through to 2009 is abysmal when compared to other asset classes.  For those of you unfamiliar with the term, “real” return means we are excluding the impact from inflation.  Between 1802 and 2009, a $10,000 investment in gold would have yielded about $26,000 by 2009.  That compares to a $10,000 stock investment would have yielded $4.8 million!

As a former equity analyst and fundamentals-based investor, the main issue I have with gold is the difficulty in valuing it as an asset class.  Remember gold doesn’t pay you dividends or interest like a stock or bond would.  This means we can’t use the standard “discounted cash flow” model to estimate how much it would could be worth based a stream of future income.  Not only does it pay you nothing, but for those who wish to own physical gold, you may actually incur costs to own it such as insurance, safe-deposit box, etc.  Really, the only perceived value of owning gold is the “bet” (also known as speculation) that its price is going to go up and somebody else will buy it from you when the price is higher.  This is known as the “greater fool theory” which to me, doesn’t qualify as a great reason to buy an asset.

Finally- is there any place for gold in a family’s asset allocation strategy?  If someone is really adamant about owning gold, I would say go ahead and put a small percentage (under 5%) of your total assets in gold.  That’s about the percentage allocation I recommend for individual stock bets or other speculative investments.  As far as the means to invest in gold:  I would suggest an ETF like the SPDR Gold Shares ETF (Ticker: GLD) and not physical gold as the ETF provides liquidity (can trade in and out anytime for minimal costs), a low expense ratio (0.40%) and you won’t incur expenses for storage, etc.

If someone still wants to own physical gold then in my view, they are betting on a “doomsday scenario” where the U.S. currency value is decimated and the only thing used to purchase real goods (food, water, medicine) would be a “hard asset” like gold.    If you’re planning for that, you should really take a chunk of that money you were going to invest in gold and instead stock your basement with lots of water & non-perishable food, grow a garden, get a watchdog and arm yourself. If we experience global chaos and a general breakdown of society, I’d much rather have food & medicine rather than something like gold which may or may not be able to be traded for food.  Bottom line: I’m no “doomsday-prepper” so when I hear those commercials for gold on the radio, I flip the station to something more sensible, like Cleveland sports talk.

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