The
Six Biggest Myths About Gold By
Nick Barisheff - Nov 18 2008 12:25PM
Gold.
People either love it or hate it. There aren’t many
who feel ambivalent toward it. Unfortunately, gold is deeply
misunderstood by investors, and that misunderstanding
is hurting their portfolio returns. Many in the investment
community trot out the old myths about gold: that it is a
bad investment; that it is very risky; that it is not a good
inflation hedge. But is there anything behind these assertions?
If investors take the time to examine the facts, these commonly
held beliefs simply do not stand up to scrutiny. It is precisely
because these myths have become so prevalent that gold is
still undervalued. Once the general public realizes these
beliefs are not valid, the price of gold will be much higher.
Myth 1: Gold Is A Bad Investment
A frequently cited argument is that since it peaked at $850
per ounce (all amounts in U.S. dollars unless otherwise noted)
in 1980, gold’s return has been poor compared to the
major stock indices. However, that peak price was a short-lived,
single-day aberration. Investors who avoided the mania phase
and purchased gold one year earlier in 1979 at its average
price of $306 per ounce also avoided any significant losses
during the subsequent bear market. The performance of different
asset classes varies from cycle to cycle. The previous cycle
from 1968 to 1980 saw the Dow Jones Industrial Average remain
flat with significant volatility, while gold increased by
2,300 percent. In the current cycle, which began in 2002,
gold has posted a compounded return of 14 percent, while 15
of the 30 Dow components are negative.
Many studies compare gold to equities over periods as
far back as the 1700s. But these studies ignore the fact that
gold’s price was fixed until 1971. Prior to that time,
gold was money and not an investment. Interestingly, virtually
none of the stocks listed in the 1700s still exist today.
Instead, the returns of major indices such as the Dow are
boosted by the removal of bankrupt companies and poor performers,
which are replaced by high performers. Three of the 30 companies
that made up the Dow in 2000 have since been replaced.
From a strategic portfolio allocation viewpoint it is easy
to see why Ibbotson Associates, one of the world’s most
highly regarded asset allocation specialists, determined that
holding between 7.1 percent and 15.7 percent in precious metals
bullion reduces portfolio volatility and improves returns.
Myth 2: Gold Is Not A Good Inflation
Hedge
The arguments against gold as an inflation hedge are usually
based on calculations arising from the intra-day price spike
in 1980. While gold did not keep up to inflation using daily
prices from 1980 to 2002, the annual average gold price has
kept up extremely well since 1971, when the price was no longer
fixed, Figure 1. During the same timeframe, the U.S. dollar
lost about 80 percent of its purchasing power. In fact, all
the world’s major currencies have depreciated by significant
amounts due to continuous excessive increases in the money
supply. The impact of this devaluation on real returns is
significant.
Figure 1 - Annual average gold price vs. annual
inflation rate since 1980
Gold had increased in purchasing power since
1971.
Conversely, gold has not only maintained its purchasing power
but increased it against all major currencies. It will continue
to do so as long as the world’s central banks keep increasing
the money supply by a greater percentage than their country’s
GDP growth.
More importantly, gold maintains its purchasing power not
only during inflationary periods, but also during deflationary
periods. An extensive study, published by Roy Jastram, analyzed
the purchasing power of gold in England and the U.S. from
1560 to 1976. Jastram concluded that gold held its value remarkably
well over time. The purchasing power of gold and precious
metals actually increases during deflationary periods because
other assets decline in price by a much greater amount than
precious metals do.
As central banks continue to accelerate the pace at which
money is printed, inflation will increase, and the purchasing
power of paper currencies will decline. This will result in
more and more astute investors fleeing to the safety of gold.
As a consequence, gold’s price should rise far
in excess of the Consumer Price Index and the true inflation
rate. In order to protect portfolios from rising inflation,
Wainwright Economics concluded that an all-bond portfolio
would need an 18 percent allocation to gold, silver and
platinum, while an all-equity portfolio would need 40 percent
just to stay ahead of inflation.
Myth 3: Gold Is A Risky Investment
Risk means different things to different investors. A pension
fund may perceive risk as a failure to meet its liabilities,
whereas an asset manager may view risk as a failure to meet
its benchmark. Most investors, however, associate risk with
a loss of their capital or underperformance of their investments
in comparison to their expectations. “Risk comes from
not knowing what you are doing,” according to Warren
Buffett.
There are many kinds of risk: currency risk, default risk,
market risk, inflation risk, systemic risk, political risk,
interest rate risk and liquidity risk. While all of these
apply to financial assets, many do not apply to gold bullion.
Physical bullion is not subject to default risk, liquidity
risk, political risk, inflation risk or interest rate risk.
In the rare circumstance of strong currencies, gold may
be subject to short-term currency risk and, at times,
to market risk. Unlike financial assets, however, gold bullion
cannot decline to zero. Gold is the only asset that can protect
wealth from non-diversifiable systemic risk.
Precious metals provide high returns at low risk
Volatility or standard deviation are often used as measures
of risk, and gold is considered to be quite volatile. However,
when annual compounded returns are plotted against standard
deviation, the individual Dow stocks are all more volatile
than gold, and all but two of the Dow stocks had poorer performance
than gold, silver, and platinum over the past eight years.
Figure 2.
Returns are important, but even more important is to compare
risk-adjusted returns. Clearly, an investment that has higher
volatility may still be attractive if the returns are appropriately
higher. Nobel prize-winning economist William Sharpe devised
the most commonly used measure of risk-adjusted performance:
the Sharpe Ratio. This ratio measures the amount of excess
return per unit of volatility. The interpretation of the Sharpe
Ratio is straightforward: the higher the ratio the better.
Bullion is unlikely to suffer underperformance risk in the
near future. Demand for gold, silver and platinum is increasing
for both commodity and monetary attributes, while annual mine
production is declining. As the price of oil continues to
rise due to production declines and increased demand, inflation
will accelerate. As central banks increase money supply at
accelerating rates, the purchasing power of currencies will
continue to decline. As these two major trends interact with
each other, the price of gold will continue to rise.
Myth 4: Gold Does Not Pay Dividends
or Interest
The Bank of England used this argument to justify selling
half the country’s gold holdings at the bottom
of the market in 1998. It wanted a “safe” investment,
one that would generate interest, and it chose U.S. treasury
bills. The gold was sold for under $300 per ounce. In the
months following that sale, the price of gold tripled, and
the value of the U.S. dollar lost 30 percent against the British
pound. The currency exchange losses plus the opportunity cost
resulted in billions of pounds in losses, significantly offsetting
any interest income the Bank might have received.
The same is true for bond investors. In an inflationary
environment, the “real” or inflation-adjusted
interest rate they receive is often negative. Gold, like any
other asset that sits in a vault, will not earn interest or
dividends, but neither is it at risk. No asset class generates
income unless you give up possession and take the risk of
not getting it back. However, gold’s capital appreciation
is many times greater than the prevailing interest yields,
while not being subject to any of the risks that interest-bearing
investments are subject to. For a comparative analysis of
holding bonds versus a systematic withdrawal program for BMG
BullionFund units.
Myth 5: Gold Is An Archaic Relic
A comparison of bullion to the larger producers shows gold
has outperformed mining stocks since March 2007
Gold is often referred to as an archaic relic with no monetary
role in today’s modern digital society. Several facts
contradict this view. The world’s central banks still
hold 29,000 tonnes of gold in their reserves. Gold, silver
and platinum trade on the currency desks – not the commodity
desks – of the banks and brokerage houses. The turnover
rate of physical gold bullion, between the nine members of
the London Bullion Marketing Association, currently averages
$24 billion per day. Trading volume is estimated at seven
to ten times that amount. Clearly, gold is still trading in
its traditional role as an alternative currency.
Myth 6: Mining Stocks Are Better Investments
Than Bullion
While mining stocks can generate impressive returns during
an uptrend in precious metals prices, they do not always outperform
bullion. It is unfair to compare junior mining companies to
bullion because of the huge disparity in risk. While successful
junior miners can generate impressive returns, over 90 percent
of precious metals discoveries never become productive
mines. A better comparison would be the larger producers.
While mining stocks have outperformed bullion during the early
stages of this bull market, gold bullion has outperformed
the major mining indexes since March 2007. Figure 3.
Mining stocks tend to be significantly more volatile and
risky than bullion, and during sharp market declines they
tend to follow the broad equity markets downwards –
even if the price of the metal is rising. During the late
stages of the bull market of the 1970’s, mining stocks
underperformed bullion. In order to adequately compensate
investors for the higher risk, mining stocks would have
to outperform bullion.
Conclusion
Investors who take the time to carefully evaluate the benefits
of bullion will realize that these commonly held myths
do not hold up to scrutiny. Those investors stand to reap
significant rewards. Investors who believe these myths are
missing out on the opportunity to add an asset class that
diversifies portfolios, protects against inflation, and
may provide better returns than traditional assets, such as
stocks and bonds.
Under a worst-case scenario of systemic risk, bullion may
be the only asset that holds its value. As these myths are
dispelled and the price of bullion rises, as many mainstream
analysts predict, informed investors will benefit from purchasing
bullion at today’s undervalued prices.
When the public at large becomes fully educated with respect
to precious metals, it will bid up the price. Considering
that global financial assets are estimated at over $180 trillion,
while total global above-ground gold is only $4 trillion (and
above-ground bullion is less than $1.5 trillion), a massive
wealth transfer event is likely to occur. It is interesting
to note that even a 10 percent switch from financial assets
to gold would result in a 450 percent to 1,200 percent increase
in the gold price.