Why Gold Could Be the Safest Investment Out There By Seeking Alpha|
October 18, 2010
A look at the past 177 years of the gold price reveals
that unexpected write-offs are non-events—gold could
be the safest investment out there.
Investing into anything is usually preceded by the thought:
what is there to win and what is there to lose? There has
been a lot of discussion about the upsides of the gold rally.
But little if nothing has been said about the potential
losses. Clearly, many people are wary of investing in gold
because they fear that the gold price could suddenly crash.
Gold has so far attracted only $5.4 billion worth of private
investment in 2010. At the same time, investors poured $22
billion into emerging market mutual funds and $155 billion
into bonds. While some commentators have labeled gold a
bubble, these numbers show the exact opposite. Being a tiny
fraction of the bond market's value, gold remains a niche
investment. The fear of the unknown holds savers away from
gold, and the media hype is not helping.
Most people perceive gold as speculative, whereas cash
(CDs), bonds, real estate and managed investment plans are
considered to be safe, conservative investments. But how
likely is a sudden crash of the gold price? If history is
any guide, it's not likely at all. In fact, gold has less
surprises for you than any of the assets mentioned above.
If you are a conservative investor, you must have a closer
look at gold.
1833-1969: Virtually no setbacks
The dollar-gold exchange rate was set to $18.93 per ounce
in 1833. Between 1833 and 1970, there was virtually not
a single notable year-on-year drop, with the exception of
1931. That year the gold price fell from $20.65 to $17.06,
a minus of 17%. But considering that in 1931 and 1932 the
general price level also dropped about 10% each of these
two years (while the gold price was set back to $20.65 in
1932), gold practically didn't lose any real purchasing
power but actually gained some during the deflationary Great
Depression.
The situation has changed since the late 1960s and early
1970s when the free gold market started to form. In 1971
the U.S. effectively abandoned the gold standard and no
longer guaranteed the fixed exchange rate of $35 per ounce.
With gold now being traded freely around the world, the
gold price became more volatile. Has gold since become a
risky investment?
1970-2010: Losses are minimal compared
to gains
Even in the post-gold-standard years, gold has never surprised
with a sudden crash. With one exception. In January 1980,
the Soviets invaded Afghanistan. The world was already shaken
by the 1979 oil crisis and the Iranian Revolution that was
drastically changing the balance of power in the Middle
East. This geopolitical earthquake made the gold price skyrocket
from $559 to $843, only to fall back to $668, all within
the one month of January in 1980. However, it is probably
safe to say that this was a very short window of opportunity
and virtually no private investors managed to buy gold at
the peak that lasted only 2 days.
In order to study how much a typical leisure investor could
lose by investing in gold, let's consider somebody who invests
very infrequently, say once a year. Let's say our person
reserves the first workday of May for this activity. So
if he decides to buy or sell gold, he'll have to do it on
this one day of the year. For this imaginary person, I computed
gains and losses for every year since 1970 by comparing
the gold prices of the first trading day of May. Let's see
what came out (I highlighted the top four losses and top
four gains):
For our investor, the maximum loss suffered in a year in
the past 40 years was -29.1% in May 1982. Frankly, I can't
think of an investment that offers notably higher safety.
Commodities, stocks (mutual funds), cash, real estate —
all of these can lose 30% or more within a year easily.
Actually, I bet that I could find annual losses of 50% and
more in every single one of those markets in the past 40
years. Even if you think of bonds, they can still easily
lose 30% or more within a year if the currency they are
denominated in drops. The same applies to cash. If your
currency loses 30% in international comparison (which is
nothing unusual), your imports (which for many people are
the main part of their consumption) will soon get more expensive
by a similar if not greater margin.
Hence, it seems that gold is one of the most stable investments
out there. It just doesn't bust. Even after the supposed
"gold bubble" of 1980, there was no bursting.
Rather, it was a gradual deflation with enough time to get
out. Even our imaginary investor didn't suffer any notable
damage and had plenty of time to exit before making a loss.
Two more interesting things can be noticed:
Each of the top four significant losses
was followed by a year with a gain
The maximum losses are generally much
smaller than the maximum gains. While the maximum annual
loss is around 20%, the top four hikes were all above
50%. In other words, gold combines limited downside with
great upside potential
The last point mentioned is not a coincidence. It is the
key logic of the gold price: Because the amount of physical
gold available for investing is limited, any crisis in the
global financial markets usually creates a run on gold and
an over-proportionate price spike. But while financial crises
set in fast, the recovery is usually slow. A recovery is
bad for the gold price, but because it is slow, the deterioration
of the gold price is gradual. Stocks and most other markets
act in the opposite way. They grow slowly and crash fast.
The gold price "grows" fast and "crashes"
slowly. This unique inverse property of gold turns it into
an inevitable cushion for any investment portfolio.
1980s, 1990s, 2000s ... what's next?
Of course, you may argue that during the 1980s and 1990s
gold was a miserable long-term investment. I would agree
with that. Gold lost 87% of its purchasing power between
1980 and 2000. But exactly because of the property described
above, everybody had enough time to get rid of their gold.
There were plenty of signals that gold would not be a good
investment in that period—interest rates were high,
emerging economies ensured attractive returns from the stock
markets and the gold price was being watered by the central
bank gold sales. Let's compare the signals from back then
with those of today:
Signals 1980s-1990s
Fed's Paul Volcker made it clear that
he was serious about fighting inflation, raising the prime
rate to as much as 21.5%
The Soviet Bloc fell apart which created tremendous, long-lasting
tailwinds for the stock markets throughout the 1990s; Asia
was booming
The IMF and central banks were selling gold and they were
loud about it. The massive sales by the Bank of England
finally brought gold to historical lows in 2001
Signals 2010s
Fed's Ben Bernanke is not serious about fighting inflation
at all, the prime rate is to stay sub 1% and a new round
of Quantitative Easing is en route
We have no fresh emerging markets to provide expansion
and growth
Central banks will become net gold buyers in 2011, after
17 years of net gold sales
The bottom line: the signals of today are the exact opposite
of those we were seeing in the 1980s and 1990s and are telling
us to buy gold. And I haven't even touched on the topic of
our broke governments that can only pay for old debt with
printed money, thus diluting the value of cash already in
circulation. Cash, CDs and bonds are outright poison at this
point. Yet, that's where most of 401k and IRA money is. It's
sad, but what can you do. If you care about your retirement,
please have a look at gold. Remember the learnings from above.
If gold peaks, it will likely deflate slowly. Because it takes
a long time to restore sanity.
And those of you who have already been praising gold's current
prospects to your friends—why not mention the downside
the next time. It is one of the best arguments for gold.