Time for Gold?

Rick Moberg

WITH STOCK PRICES so high and interest rates so low, many folks are thinking about buying gold. Tempted to take the plunge? Ponder these nine issues:

1. No income. Gold pays no interest or dividends. That means gold’s return hinges entirely on its price going up. Gold ownership also means you must forgo the interest and dividends you’d have otherwise earned on alternative investments. Still, with interest rates so low, the opportunity cost of owning gold—at least in terms of lost income—is very low right now.

2. Limited utility. Gold doesn’t have much practical use. According to the World Gold Council, an industry trade group, demand for gold over the past 10 years came from jewelry and technology manufacturers, and from financial customers, such as exchange-traded funds and central banks. Financial customers weighed in at about 50% to 60% of that demand. The upshot: Gold prices depend on these customers buying a product that has no actual utility to them.

3. Valuation is difficult. Gold lacks the fundamentals needed to determine fair value. You can’t discount expected future cash flows, because gold has nothing to discount. Other asset valuation techniques, such as multiples of earnings or revenue, also don’t work. Instead, gold prices fluctuate wildly based on short-term supply and demand factors, including production levels, discoveries of new reserves, central bank actions, and cycles of investor fear and euphoria. In essence, gold’s price is determined by what people are willing to pay for it at any given moment.

4. Lackluster returns. Gold began to trade freely in 1971, when the U.S. went off the gold standard. Returns since then haven’t been attractive compared to stocks. If you invested $1,000 in gold at year-end 1971, it would have grown to about $50,000 by year-end 2020. That same $1,000 invested in the Wilshire 5000 total stock market index would have grown to about $185,000.

Gold skyrocketed in the 1970s due to its liberation from the gold standard and unusual economic conditions, notably rapid inflation. If these events reoccur, gold could be a home run again. If not, it could be a drag on investment performance. Suppose we ignore the 1970s and look only at the past four decades. Over that stretch, a $1,000 investment in the Wilshire 5000 grew to some $73,000, while a $1,000 gold investment grew to about $3,000.

5. Stock market hedge. Gold has been a reasonably good way to diversify a stock portfolio’s risk, because gold prices tend to move independently of stock prices. This has been the case for much of the past 50 years, although not so much over the past five years. While we can’t know for sure, gold will likely continue to be a good stock diversifier, and owners may benefit through reduced overall portfolio volatility and gains from rebalancing. The downside: Despite any performance boost from rebalancing, this hedge usually carries a cost—in the form of lower overall portfolio returns, because of gold’s drag on long-run results.

6. Inflation hedge. Gold has a reputation as an inflation hedge, but reality suggests otherwise. There have been periods since 1971 when gold outpaced inflation, but there have also been long periods when it didn’t. Notably, gold wasn’t up to the task during the 30-year period from 1981 to 2010, when it didn’t keep pace with inflation.

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Stocks, inflation-indexed Treasury bonds and natural resources do a better job of protecting against inflation. Stocks have delivered significantly higher returns than gold. Inflation-indexed Treasurys have an income stream that is directly tied to inflation. And natural resource prices are more highly correlated to inflation than gold.

7. Currency hedge. Gold tends to be negatively correlated with the U.S. dollar, which means it rises in value when the dollar weakens. A weaker dollar creates an inflation problem for Americans, because it takes more dollars to buy goods and services from foreign suppliers. Some U.S. investors hedge this risk with gold.

But do you really need to? A prolonged decline in the dollar is unlikely. The dollar is the world’s reserve currency, the U.S. is fundamentally sound and our growth prospects relative to other developed countries are favorable. On top of that, as I noted in point No. 6, there are better ways to hedge inflation.

8. Fear hedge. Gold is undoubtedly an effective hedge when people become fearful or major crises arise. Global banking systems are quite stable under normal circumstances, but can become unstable when political, economic and natural disasters arise. Gold exists outside of these systems, so its price tends to rise during turbulent times and fall when conditions return to normal. You can make money during these cycles, but knowing when to get in and out is awfully difficult.

Some people also believe gold will be a valuable currency in a post-apocalyptic world where banking systems have disappeared altogether. But who knows? Gold will only be worth something if the people who own food, shelter or medicine are willing to exchange them for gold. Owners may be reluctant to make that swap if it jeopardizes their own survival.

9. Unfavorable taxation. Gold is taxed unfavorably when held in taxable accounts. Federal and state governments consider gold to be a “collectible.” At the federal level, long-term capital gains on collectibles are taxed at ordinary income tax rates, but with a cap of 28%. By contrast, long-term gains on traditional investments are taxed at 0%, 15% or 20%, depending on your income level.

Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. Check out his previous articles.

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Kevin Knox
Kevin Knox
1 year ago

While there are some good points here the misinformation outweighs them. Rather than writing clearly about gold, for the most part the author trots out the same tired “no inherent value” tropes one can read about ad nauseum on Bogleheads and other forums.

This article addresses gold’s history and possible deployment in portfolios far more skillfully:

The key mistake, in my view, is looking at gold in isolation rather than as a component of a portfolio. I guess I should add that far from being a gold bug myself I hate owning the stuff but it can help so much with sequence-of-returns risk and boosting safe withdrawal rates during retirement that I prefer to have a modest allocation to it.

John McHugh
John McHugh
1 year ago

One more possible reason, with a story (sorry):

Several years back I adopted a disciplined buy-hold-rebalance portfolio with stock index funds representing several asset classes (ref. Paul Merriman, streamlined). In January, on the threshold of retirement, my annual rebalance was to 50/50 stocks/2-year treasuries.

By early Feb that allocation was out whack for good reasons so I did something wild and crazy: Took a profit on the one-month gain and put it a gold ETF. I’m now 49/49/2.

One more backgrounder: At the same time I adopted the rules-based system I also embraced a new guru for all things related to the future, Sergeant Schultz, “I know nothing.” (It’s been liberating.)

So… In 2020 I perceived a new source of risk: “Crazy.” Not to get political, but the kind of social crazy that includes sporadic violence and elites abandoning the “reality principle.”

That’s why I bought the gold, not the inflation risk. My opinion is that bad inflation is a threat, but the good Sergeant always reminds me now, “You know nothing!” so inflation fear was not why I bought gold.

(Schultzie gets backup from Taleb, from whose Black Swan I took that humans are lousy at making predictions – so avoid doing it on anything more important than whether there will rain for the Saturday picnic.)

Last edited 1 year ago by John McHugh
1 year ago

Friendly Addition to the list…

10. Cost to Secure. Gold takes up space and requires storage. When you buy it, the seller may require payment for secure transportation.

  • You could rent from a company that specializes in storing & securing precious metals. And maybe insure against loss. Those costs cut into the profit margin and recur year-after-year.
  • You could put that gold in a bank’s safe deposit box. And again, you might want to insure against loss because the lease agreement for safe deposit boxes usually excludes responsibility for loss (or alleged loss) of money, coins, or currency… a lease agreement typically also requires the renter to agree that the bank’s liability is $xx,000. As before, these recurring annual costs cut into profit margin.
  • You could buy a safe for your home – a one-time expense. And since most home insurance policies limit liability for cash, currency, and collectables, there’s that insurance thing again.
  • You could simply bury your stash in the yard or sew it into the hem of your drapes. That’s free, but it’s insecure. And it creates a new type of risk… the risk that your hidden treasure will inadvertently remain hidden from heirs & legatees.
Roboticus Aquarius
Roboticus Aquarius
1 year ago

I’ll start off by saying I have no faith in gold, for many of the reasons you post.

Interestingly enough, gold has been a fair substitute for Intermediate Treasury bonds in a 60/40 portfolio since it became possible to buy it in the early 1970’s. A gold portfolio actually does better, but I discount that somewhat since it took some time for a retail gold market to develop. If you start in 1974, the two portfolios are pretty close when it comes to return. The risk profile for the gold portfolio is worse vs using treasuries, as you might expect.

I would still rather use Int Trsy bonds (or a Total Bond Fund) in my portfolio (I have access to a stable value account, though, so I use that instead.) Bonds are a segment of one’s portfolio whose valuation just won’t decline much (the modest caveat being long bond funds), and that’s a valuable thing in tough times.

James McGlynn CFA RICP®
James McGlynn CFA RICP®
1 year ago

Rick good synopsis of gold’s history. I think gold’s appeal is currently being supplanted by bitcoin as well as far as price appreciation and a means of exchange. You also mention natural resources as a good inflation hedge. The gold/oil price ratio is still fairly high too- implying energy prices are a bargain versus gold.

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