We labour mightily to haul gold out of dark mines only to hide it again in dark bank vaults. And to what end?
Some investors use gold to protect against potential inflation and paper currencies which have no intrinsic value. But despite loose monetary and fiscal policy, inflation is less of a problem today. We warn against buying lots of gold, given its drawbacks.
Gold stocks can face many problems
One disadvantage with gold stocks is that they can trade for more than they should. When the price of gold is high, gold stocks often trade at excessive price-to-cash-flow-per-share and price-to-earnings ratios. In most industries, investors would walk away when these ratios are excessive. But price-to-earnings ratios matter less with cyclical gold stocks.
You can buy gold itself. This will avoid the problems of any given gold stock—a sudden jump in costs, a drop in ore grades, strikes, expropriations, floods and so on. But holding physical gold means you’ll earn little, if any, income. More likely you’ll have to pay for its safe-keeping. One way around this is to buy gold ETFs (Exchange-Traded Funds).
Diversified stock portfolios beat gold
Another disadvantage is that unforeseen events can roil gold prices. For instance, geopolitical instability can drive up the price of gold. The trouble is, how do you plan for unforeseeable events?
More important, gold has a terrible long-term record as an investment. For more than 200 years, gold has delivered very poor total real (inflation-adjusted) returns. Jeremy Siegel, a professor of finance at the University of Pennsylvania’s Wharton School, studied the returns of different classes of investments from 1802 through 2012. One was gold.
Say one of your ancestors had invested a dollar in gold in 1802. At the start of 2013 it would’ve risen to $4.52. That’s a real (inflation-adjusted) return of just 0.7 per cent a year, Professor Siegel notes. Had your ancestor invested a dollar in US stocks, it would’ve turned into $704,997 at the start of 2013. That was a real return of 6.6 per cent a year.
Gold is a drag on your portfolio
Professor Siegel concludes: “In the long run, gold offers investors protection against inflation, but little else. Holding these assets will exert a considerable drag on the return of a long-term investor’s portfolio.” Indeed, after a run-up in the price of gold in 1979 and 1980, gold subsequently fell and generally drifted down in price until after 2000.
Still, some investors worry that loose monetary and fiscal policies plus the debasing of currencies by some governments will lead to higher inflation. The printing of paper currencies is no longer held back by the gold standard monetary system. Higher inflation lightens government debt burdens. They get more taxes from higher nominal salaries and profits. Inflation lets them repay debt with depreciated currencies.
If you’re worried about inflation and paper currencies, buy ‘hard’ assets. Given its poor long-term record, limit gold to a small part of your portfolio.
Modern portfolio theory does have a place for gold
Harry Markowitz won a Nobel prize in economics for developing ‘Modern Portfolio Theory’. His idea is that an investor should judge an investment by how it works within his or her overall portfolio—not in isolation. If that investment raises the return of the portfolio or reduces its risk, then the investor should buy it.
Gold is risky. In uncertain times, strong demand can drive up its price. When investors are confident, the price of gold can drop. But Markowitz’s lesson is that we should look at how an investment fits within our portfolios.
Gold can do well in crises—just when most other investments do poorly. Similarly, gold often does worst in good times when other investments do well. That is, it has negative ‘correlations’ with most financial assets.
This means that gold can stabilize your portfolio or reduce its risk in turbulent times. But you should still limit your holdings of gold given its drawbacks.
This is an edited version of an article that was originally published for subscribers in the November 13, 2020, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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