I have a burning question for you:

If investing in gold is so great, why is it marketed like ShamWow?

If you haven’t seen the ShamWow commercials, they’re pretty funny:

I’ll start with this: gold (and other commodities) should play some role in any well balanced investment portfolio. But the hype surrounding gold really does feel a little slimy to me.

Since this is one of the most often asked questions I’ve had in over 20 years of advising clients, I figured I’d dig a bit deeper. Should you be investing in gold? If so, how much?

 

Investors Buy Gold For Different Reasons

Let’s start by dissecting why anyone would want to invest in gold. It doesn’t produce a profit, it doesn’t make the world a better place, it’s simply just a lump of metal. So why invest in gold?

  1. Many investors buy gold for the performance. They anticipate it will grow in value. Remember, gold doesn’t pay a dividend. It’s just a piece of metal, so any gains must be capital in nature and come in the form of buying low and selling higher.
  2. Others invest in gold as an inflation hedge. One of an investors biggest fears – especially a retired investor – is inflation. After all, if the real cost of goods and services you need to live rises substantially you’ve only got so many dollars to purchase those things with. Those dollars then run out faster! For this reason, some investors buy gold as an inflation hedge.
  3. Some invest in gold as a diversifier. We all know the old adage “don’t put all of your eggs in one basket!” Just like we diversify our stocks into mutual funds with hundreds or thousands of stocks, gold can be added to an investment portfolio as a diversifier. Gold – and other commodities – are quite non-correlative after all. They don’t go up and down in value along with most other assets. Rather, gold and other commodities fluctuate in value quite independently of the major asset classes (stocks, bonds, and cash).
  4. Still, others invest in gold out of fear. They fear that the dollar will collapse and armageddon is around the corner. If the dollar is worthless, all trade will be done with chunks of gold. The value of gold would then rise, and you could trade goods and services with it.

For the latter of the bunch worried about armageddon, I recommend forget the gold and invest in bullets and guns. After all, you’re going to need to protect your gold stash somehow.

For the first group of the bunch, let’s take a look at gold’s investment performance.

 

#1 Investing In Gold For Performance

The “gold buggers” claim it’s a good investment because it grows over time. But does it really?

This claim is based entirely on 2 of the last 4 to 5 decades, the 70’s and 2000’s. Indeed, if you were to look only at those two time periods, gold performed amazingly well!

 

How Did Gold Fare During The 2000’s?

 

Gold performed really well during the 2000's!

Through the turbulent decade of the 2000’s, gold outperformed every major asset class by miles!

 

Let’s see, in the 2000’s our economy dealt with:

  • Tech bubble bursting
  • 9/11 terrorist attack
  • 2008 real estate meltdown
  • Record oil prices (and recent collapse)
  • Numerous natural disasters
  • Wall Street scandals

Gold became a “safe haven” so to speak. It was the place to be invested, because nothing else felt safe or good.

Consequently, gold dominated every major asset class through the first decade of the 2000’s, From 2000 through 2011 adjusted for inflation:

  • Gold +12.3%
  • S&P 500 -1.88%
  • MSCI Non-US Stock Index – 1.4%
  • CRSP Small Cap Stock Index 3.9%

Don’t be fooled however! The stock market (as measured by the Dow Jones) dropped into the 6,000 range in 2008. Now it’s nearing 20,000! Investments are volatile and tend to move in cycles, both up and down.

Gold in 1999 was at a 20 year low! This isn’t entirely different from the Dow Jones being in the 6,000 range in 2008. Gold started the decade at such depressed prices, it was destined for some recovery. Does that alone make it a good investment?

 

What About The 1970’s? How Did Gold Perform?

The 70’s were another very strong period for gold’s performance:

Investing in gold during the 1970's was a good move!

Gold performed incredibly well during the 1970’s, dominating all other asset classes.

 

Again, an investment in gold during the 1970’s proved to be quite smart! But what happened in 1971?

I wasn’t “quite” born yet, but I was close. While I don’t remember this, the United States went off the gold standard in 1971. The price of gold was reset to $38 per ounce.

Gold and the dollar were no longer tied together in 1973. This finally allowed the value of gold flexibility to float on it’s own.

Here’s the rub: investors couldn’t actually buy gold until 1975. You may not remember, but there were restrictions on owning gold put in place in 1933. Investors couldn’t even buy it! This means most people missed a good chunk of gold’s appreciation – the first half of the 1970’s.

How did this affect performance? Gold for the entire decade (January 1970 to January 1980) was +27%. But since you couldn’t actually invest in gold until 1975, how do the real results shake out?

From 1975 to 1980 inflation adjusted annualized returns were:

  • Gold +18.4%
  • CRSP Small Cap Stock Index 28.9%
  • S&P 500 +6.9%
  • MSCI Non-US Stock Index 9.4%

Also remember, the first part of the 1970’s the United States dealt with:

  • War
  • An oil crisis
  • A massive stock market bear market (’73 & ’74)
  • Worldwide conflict and tension (Middle East and USSR)

In fact, doesn’t the early 1970’s sound a lot like the early 2000’s??? From a political and economic unrest viewpoint, I think we can all agree they have remarkable similarities.

Does it make logical sense to invest in gold based on strong performance for 15 years (discounting 71 to 75 when you couldn’t invest in gold) out of the 40 year sample period?

 

Gold’s Real Performance

Investing in gold has been a volatile proposition.

Investing in gold has proven volatile over the years.

I’d argue it doesn’t make sense to be bullish on gold based on past performance. 15 out of 40 years sampled isn’t enough to get me excited about gold as an investment.

The stock market after all, returns positive numbers roughly 3 out of every 4 years. Gold’s 15/40 years is less than 40% of the time. I’m sure there are other positive – yet unremarkable – years for gold. Regardless, it doesn’t have the strong long term results of the stock market.

Gold’s performance relative to other investments throughout the entire sample period is quite bland (putting it nicely):

 

Gold isn't a good investment over the long term.

The real inflation adjusted growth of a dollar over the 40 year period shows gold isn’t a great investment after all.

 

During the full time period (even when you couldn’t own gold from ’71 to ’75), inflation adjusted annualized returns are:

  • Gold +4.9%
  • S&P 500 +5.3%
  • MSCI Non-US Stock Index +5%
  • CRSP Small Cap Stock Index +7.3%

In reality, since investors couldn’t own gold until 1975, gold’s allure fizzles sharply. From 1975 through 2011 inflation adjusted annualized returns are:

  • Gold +1.82%
  • S&P 500 +7.1%
  • MSCI Non-US Stock Index +5.5%
  • CRSP Small Cap Stock Index +10.6%

 

Gold Plain Stinks In Normal Economic Times

Let me clarify that headline. You can see similarities in political and economic turbulence in the 1970’s and 2000’s. In the ’80’s and ’90’s, not so much.

I’m referring to the two decades from 1980 through 1999 as more “normal” times. During this 20 year period, gold was a complete BUST!

Investing in gold from the '80's through the '90's was a horrible mistake!

During normal economic times, gold is one of the worst investments you can possibly imagine!

The time period above – the “normal” time period (if there can be one) – had massive global economic expansion, and far less political anxiety. The stock market went on a tear, giving investors dynamically positive returns!

In inflation adjusted annualized returns:

  • Gold -6.5%
  • S&P 500 +13.3%
  • MSCI Non-US Stock Index +9.2%
  • CRSP Small Cap Stock Index +10.7%

In real terms, a dollar’s worth of gold dropped to 26 cents over that 20 year period! Yet your stock investments – even your bond investments – had substantial and positive returns.

 

#2 Investing In Gold As A Hedge

Some people buy gold as an inflation hedge. Inflation is a nasty fact of life after all, decreasing our purchasing power over time as consumer prices march higher and higher. But is gold a good inflation hedge?

Investing in gold as an inflation hedge leaves a lot to be desired.

Is gold really a good inflation hedge? Time has shown us it’s really not!

From 1980 to 2011, gold’s price rose quite a bit. The problem is the rise is in nominal dollars. After you adjust gold’s price for inflation, the returns aren’t so great.

For the 30 or so year period ending 2011, gold rose from $1 to $3.05 in nominal dollar terms. Inflation during the same timeframe (as measured by the Consumer Price Index), grew at an annualized rate of about 3.4%.

Once you account for inflation, gold grew from $1 to $1.04. Gold therefore, simply kept pace with inflation. Does that make it a “hedge”? Or would you be better off allocating your gold investment to T-bills?

T-bills grew roughly 5.3% annualized in nominal terms, or about 1.8% in inflation adjusted terms. The math is simple, you would have been better off buying T-bills. You would have nearly doubled your inflation adjusted returns over the time period.

Keep in mind, we’re comparing and contrasting gold to inflation. Inflation isn’t very volatile, rather it’s quite consistent over time.

From 1970 through ’05, the Consumer Price Index’s standard deviation (a measure of volatility) was 1.2%. Gold’s standard deviation was 19%. This makes the price of gold 15 times more volatile than the consumer price index.

In some periods, gold has indeed served as an inflation hedge. In others, it’s failed miserably. It’s substantially more volatile as well!

Gold as an inflation hedge is truly “hit or miss”!. Since we never time the market (or any investments), I choose not to employ a “hit or miss” strategy.

 

#3 Using Gold To Diversify Your Investment Portfolio

Finally, some investors choose to invest in gold to diversify their other investments. Gold after all, is fairly non-correlative to most other asset classes.

Gold doesn’t fluctuate up and down with the stock or bond markets per se. Rather, it does it’s own thing! Stocks going up? It’s a hunk of metal, it doesn’t care about stocks, it may even drop. Bond’s going down? Gold doesn’t care, it marches to the beat of it’s own drummer.

Since gold doesn’t care about any other asset classes, it can be viewed as a good diversifier. The problem is gold is so much more volatile than most asset classes.

Above I mentioned the standard deviation of gold at around 19%. A 19% standard deviation rivals that of small cap stocks on the exchange. In other words, gold’s price is HIGHLY VOLATILE!

While diversification is generally good, and gold can prove to diversify a well constructed portfolio, keep in mind how gold produces that return.

 

Investments Should Generate Economic Returns

For an investment to be “worthy”, it should generate some investment return right? That is after all what investors want… more money coming out than they put in! But gold on it’s own doesn’t produce any real profits or growth.

Here’s what I mean by this. Gold is a shiny metal. It’s not a business. It doesn’t promise to pay interest or dividends. Gold doesn’t have the capacity to produce profits in a free market.

Gold – as that simple shiny piece of metal – is nothing more than an opportunity to gain or lose investment capital based on future supply and demand constraints. Should the demand rise for gold, the price will rise as well. Conversely as demand drops, the price drops as well.

What About Gold Versus Stocks And Bonds?

Contrast gold with a bond. A bond is a promise by the issuer to repay your principal investment along with interest payments over time. The issuer makes the money to pay you principal and interest through their business, municipal, or federal activities. There’s real economic principles at work here!

Contrast gold with a company’s stock. The company issues shares on the open market in order to finance growth.

Let’s say it’s an ice cream truck business. The company sells you some shares so they can buy more trucks and hire more drivers.

The ice cream company expands, they grow profits by selling more ice cream to more kids. As a shareholder in the ice cream company, you’re a fractional owner in those profits. There are real economic principles at work here!

Gold on the other hand, is just gold. It doesn’t produce anything. You can’t buy a Slurpee at 7/11 with it, and you can’t force it to grow and expand like a business. It’s just a hunk of metal.

 

What’s The Real Value Of Gold?

Years ago, I found this interesting quote from Warren Buffet. Mr. Buffet is considered by some one of the greatest investors of all time. In the February 2012 issue of Fortune Magazine, he said:

 

Today, the world’s gold stock is about 170,000 metric tons. If it were all melded together, it would form a cube of about 68 feet per side (fitting within a baseball infield). At $1,750 per ounce, it would be worth $9.6 trillion.

With the same amount of money, you could buy all US cropland (400 million acres with output of $200 billion annually) plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually), and still have about $1 trillion in cash.

 

So what would you buy? All of the farmland in the US, 16 Exxon Mobil’s, and pocket a trillion dollars? Or would you buy all of the gold in the world? It is a pretty shiny metal after all!

 

So How Much Gold Should You Invest In?

Using gold as an investment hedge, or a diversifier, or even for what you expect may be good performance are all reasons to own gold. They may be faulty for the many reasons mentioned above, but they’re reasons nonetheless.

So if any of these arguments to invest in gold are valid, how much should you own anyway? I’d argue that since the reasons to invest in gold are shaky at best, not a lot!

Gold as a diversifier, gold for performance, gold as an inflation hedge – they’re all reasons to own gold in small amounts! Gold is certainly not an asset class you want to invest a large portion of your assets in.

Small amounts, such as 1% to 5% of your entire portfolio, are reasonable to invest in gold. I’d never put 10% or more into gold, simply because it doesn’t produce any economic return (like a business or a company stock).

As part of a larger commodity allocation, gold makes some sense. Commodities, in a broader sense, also proves to be an inflation hedge and a diversifier throughout certain periods of time.

Nonetheless, as part of an overall asset allocation plan, 10% allocated to commodities is approaching the “discomfort zone” for me.

 

Investing In Gold Summary

While investing in gold has had brief periods of great returns relative to other asset classes, those periods have been short lived. Over long periods of time, gold has failed to deliver any substantive value to an investment portfolio.

Consider keeping your allocation to gold – and all commodities – under control. Use it for what it is, a non-producing investment asset which may provide some returns, may provide an inflation hedge, and may prove to be a good diversifier as part of an overall well balanced investment plan.