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The Case Against Gold

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Two thousand years ago, a Roman senator could buy a really spiffy, top-of-the-line toga for about the equivalent of one ounce of gold. The Armani family would hand-tailor his garment from the finest imported fabrics and most stylish dyes–a real power suit, guaranteed to turn heads while sending a strong message of restrained power and worldly sophistication.

During the Civil War, a fashionable man’s suit cost about the same as an ounce of gold. Today, with an ounce of gold hovering at about the $300 level, careful shopping will buy you a fair off-the-rack suit at a chain department store, but the Armanis won’t let you in the store for just the price of an ounce of gold.

Using this highly anecdotal “evidence” I conclude that even long-term investors have not experienced significant appreciation from holding gold. Yet there is a small but committed cadre of “gold bugs” that hold the metal in almost mystical reverence as the ultimate store of value. Their endlessly repeated mantra that every investor should hold 10% to 20% of his or her assets in gold hasn’t changed a note in my lifetime. What can be behind gold’s emotional appeal, and how did it get such a lock on our collective consciousness?

The Glitter of Gold

Gold has been known and treasured for more than 3,000 years in both the New World and Old. It’s easily worked into elaborate designs, almost indestructible, and beautifully lustrous. But when King Croesus of Lydia issued the first gold coins in 560 B.C., gold became money. The two have been linked ever since.

As a medium of exchange, gold had a lot going for it. It’s scarce. All the world’s gold would fit into a cube only 60 feet on each side. Production is limited, and output cannot be increased rapidly or inexpensively. Gold is easily concealed, durable, and portable. A family could hide their wealth by burying it in the ground. It won’t rust or decay, and could remain safely hidden away from both the tax collectors and thieves. (A fair amount of the world’s gold has been lost as owners die off without revealing their hiding place to their heirs.) If your clan, tribe, religion, or family was liable to come under occasional attack, you could carry your wealth with you if you were fortunate enough to escape. Finally, unlike printed money, it’s hard to counterfeit, and the government can’t just make more when the time is not convenient to balance the budget. So, it’s easy to see how, over the centuries, gold became the accepted proxy for wealth, security, and permanence.

Gold Bugs and Bears

However, in today’s world, an offshore investment account and a credit/debit card may perform many of gold’s previous functions much more effectively and conveniently. If you are concerned about your country’s inflation rate, you can always buy assets denominated in another currency through your Cayman Island Trust. If you think you may have to beat a hasty retreat from an unfriendly government, you can send assets via wire to a safe, friendly island in the sun. It’s so much easier than sewing it in your suit coat lining or loading up the submarine with those heavy gold bars.

Owning gold bars as a financial asset is inconvenient compared with the modern alternatives. Bars must be stored, protected, and insured. They earn no dividends, and while they may act as an inflation hedge, they haven’t produced any real growth.

Few mutual funds actually own bullion. As you would expect, those funds closely track the price of gold. Other “gold” funds own gold-mining stocks. The mining-company stocks are greatly influenced by the price of gold, but other factors influence their performance. The companies are a for-profit business subject to all the normal business risks. For a mining operation, it’s possible to find more gold, have the existing mines peter out, pay more for labor, or lower costs because of better technology. An increase in the price of gold won’t do you much good if you have come to the end of your vein. It’s also possible that the next rock you turn over may reveal riches beyond your wildest dreams. Gold-mining stocks tend to be much more volatile than the metal itself, due to the financial leverage of the operating companies.

While there is stable industrial, dental, and jewelry demand for gold, the market is subject to enormous political risk. If governments sell gold, bad things happen to the world market price. It shouldn’t be a big surprise that the gold companies have a marketing association, complete with a propaganda arm that includes a public relations staff and lobbyists. High on their list of concerns is legislation aimed to keep gold as a central bank reserve backing the world’s currencies. Right now they are busy reminding Europe of the benefits of having the ECU linked to gold. There are ongoing efforts to prevent central banks from dumping their gold on the market to raise cash or balance the budgets. Funny how the gold producers seem much more keen on the problem than most economists or central bankers.

Of course, the gold producers are anxious that you not forget the long-term benefits of owning gold as an investment. Their literature is full of references to stability, inflation hedges, and the perils of owning “paper.” They are quick to note that gold actually rose in value during the crash of 1987; however, they are somewhat slower to point out that U.S. Treasury bills did better! Much is made of the low correlation to other asset classes and the gold-bug creed that everyone should devote 10% to 20% of their portfolio to gold as a hedge against economic collapse.

Gold Has Been A Wild Ride….

As this graph of gold spot prices from March 1988 through March 1998 shows, gold prices have zigged and zagged vertiginously, while trending mostly downward in price. Source Bloomberg.

On the whole, gold stocks are extremely volatile. Afterburner climbs are often followed by kamikaze dives. It’s not unusual to see gold at both the top of the funds list for the current quarter and at the bottom of the list for the trailing 12 months. The average precious-metals fund has a standard deviation of 26.5 over the past 10 years, compared with the domestic-equity fund’s average of 15.6. It’s hard to think of another asset class with such high risk–and such disappointing returns.

…But It Hasn’t Paid Off

1 yr ret 3 yr ret 5 yr ret 10 yr ret
Wilshire 5000 Index 47.74 31.14 21.27 18.13
JSE Gold Index -45.14 -26.74 -15.77 -12.28

 

 

While the overall stock market, as reflected in the Wilshire 5000 index, has soared over the past decade, gold has been a perennially losing investment. Source: Morningstar Principia.

It’s not enough to build the case for an asset class on its low correlation to other asset classes. The chance to lose money while every other asset class on the planet is making money is not an appropriate rationale. Each asset class should also have positive expectations, and risk levels appropriate to the expected rates of return. In other words, I don’t see any point in an asset that won’t pull its weight by generating real positive returns over the long haul. Gold may occasionally dazzle, but it flunks the test.