It’s said that gold comes out of dark underground mines only to disappear into dark bank vaults. When we publish our gold stock survey, we do outline the yellow metal’s many disadvantages. But a Nobel Laureate reminds us that there’s a time and a place for everything.
Gold peaked at US$1,908 an ounce in August 2011. Some investors use gold to protect against potential inflation and the risks of paper currencies. But inflation is less of a problem these days, especially with moderate oil prices. We warn against holding lots of gold, given its drawbacks.
One disadvantage with gold stocks is that they often 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.
The prices of gold producers are mixed despite a modest rise in price of gold. With the price more stable recently, we rate as ‘buys’ eight of the 15 gold stocks we recently surveyed.
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 Exchange-Traded Funds (ETFs).
You can’t plan for unforeseeable events
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 can 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 2006. One was gold.
Say one of your ancestors had invested a dollar in gold in 1802. At the start of 2007, it would’ve risen to $1.95. That’s a real return of just 0.3 per cent a year, professor Siegel notes. Had your ancestor invested a dollar in US stocks, it would’ve turned into an inflation-adjusted $755,163 at the start of 2007.
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 the poor finances of some governments in Europe will lead to higher inflation. The printing of paper currencies is no longer held back by the gold standard monetary system. And central banks have pumped money into their financial systems. Higher inflation lightens the debt burdens of governments. 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.
Nobel prize winner offers a rationale for owning gold
Harry Markowitz won a Nobel prize in economic sciences 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 October 27, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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