The following is a guest post from Marotta Wealth Management.
Gold ownership has grown in popularity over the past five years. Fearful of monetary or societal failure, many hope that owning gold will bring them peace of mind. Advocates also suggest that some amount of gold is part of a balanced diversified portfolio. Arguments can be made for gold, but its investment properties are not among them. The optimum asset allocation to gold in an investment portfolio is zero.
Through an executive order, President Roosevelt made the possession of monetary gold a crime in 1933. Then in 1971, President Nixon took the United States off the gold standard. This move triggered a high rate of inflation that severely devalued the dollar. In 1974 private ownership of gold was allowed once again, but it could not be used as payment in contracts.
Now, we can both own and pay with gold, but another president could make it illegal again. Thus some people believe you should buy gold now before that happens.
Today, the U.S. dollar is only valuable because the government has declared it legal tender and we act accordingly. The dollar has no intrinsic value and is not backed by any reserves of gold or silver. It is a "fiat" currency. If a significant portion of society ever lost faith in its value, it would no longer be accepted despite government edict. We would experience hyperinflation, and the dollar's purchasing power would fall precipitously.
Historians cite examples of fiat currencies imploding after hyperinflation, making these worries a real concern. Since 2008 the U.S. government has been actively devaluing our currency. Holding interest rates low with quantitative easing has kept inflation higher than normal. Meanwhile the government has kept the official reports of inflation artificially low.
This situation engenders deep concern. The value of gold is heavily correlated to fears of economic or political collapse. It is argued that gold could protect us from such a catastrophe.
This position makes gold a fallback currency, not an investment. The argument against gold as an investment is twofold. First, gold has an expected return that is little more than inflation. Second, gold is extremely volatile.
Expected returns are calculated by analyzing long-term movements in price. Although gold's price is highly volatile, its value averages little more than the increase in inflation.
Jeremy Seigel's book "Stocks for the Long Run" includes the growth of $1 of various investments from 1802 through December 2006. After being adjusted for inflation, gold grew from $1 to $1.95 while stocks grew from $1 to $755,163. At those rates, stocks have an average annualized appreciation over inflation of 6.86%, whereas gold is just 0.33% over inflation.
Gold and silver generally hold their value. They appreciate approximately by inflation. Little or no additional value is added. But gold and silver also rise and fall with global fears. They can be very volatile, even when measured in inflation-adjusted dollars.
Although gold tends to hold its purchasing power, it has not done so for the past 33 years. In January 1980, gold reached a high of $850 an ounce ($2,399 in today's dollars). For the next 21 years the price of gold dropped to a low of $256, losing over 70% of its value. Since bottoming out in 2001, it has regained about half its value.
Gold’s volatility means it has both positive and negative runs. Gold advocates try to make their case based on the positive returns from the bottom of the gold market in 2001 until recently. They ignore the 21 years of decline in favor of the recent 12 years of growth. But any serious analysis for portfolio construction must look at long-term averages.
In 2013 gold is currently trading at $1,368.75. Adjusted for inflation, it has the same purchasing power as it did in 1979. For the past 34 years, gold has just kept up with the official figures for inflation, albeit gyrating wildly above and below the Consumer Price Index.
Long-term averages make gold look like a safe store of value. But if you purchased gold at its height in 1980, you have lost more than half your buying power. In contrast, stock investments since 1980 have increased their purchasing power more than fourfold.
Modern portfolio theory advocates blending asset classes to maximize expected return and minimize portfolio volatility. Portfolios constructed according to these specifications have their risk-return ratio on the "efficient frontier," a curve depicting the best possible risk-return combinations of asset allocations. Assets with low expected returns and high volatility are not part of the efficient frontier.
For any portfolio that includes an allocation to gold, there is a better portfolio, one with a higher expected return or a lower volatility that has a zero allocation to gold. The efficient frontier teaches us that the optimum allocation to lower performing, higher volatility investments is zero. Therefore, the optimum asset allocation to gold over long periods of time is zero.
Gold is not an investment. It is better described as a store of value. We use the term "investment" to describe something that pays you money. Stock ownership is an investment because it has earnings or at least the hope of future earnings. Bonds pay interest. Rental properties collect rent.
Using this definition means many items of value are not deemed investments. For example, a fur coat, original artwork, or comic book collection are not investments. Neither is a beach house reserved for private use. These items all have value. Some of them may even appreciate at a rate greater than inflation. But as a whole, they have an expected appreciation that is little more than inflation.
A wise rule is to opt only for investments. Gold is a safe store of value but not an investment. Cash isn't a safe store of value. When adjusting for inflation, $1 has dropped to just $0.06 in buying power over the last 200 years. Cash doesn't pay you money and is not an investment. The correct asset allocation to dollars is also zero.
Holding physical precious metals may be useful at times, but it is a mistake to purchase gold for its investment potential. The diversification of modern portfolio theory does not mean buying a little of everything. Rather it means finding the most efficient blend of assets to provide the best chance of meeting your long-term financial goals.
The optimum allocation to gold is always zero because its return is too low to be a real investment and its volatility is too high to justify its low return. If you choose to purchase gold, limiting it to less than 3% of your portfolio will protect you from compromising financial goals that depend on appreciation above inflation.
Gold ownership has grown in popularity over the past five years. Fearful of monetary or societal failure, many hope that owning gold will bring them peace of mind. Advocates also suggest that some amount of gold is part of a balanced diversified portfolio. Arguments can be made for gold, but its investment properties are not among them. The optimum asset allocation to gold in an investment portfolio is zero.
Through an executive order, President Roosevelt made the possession of monetary gold a crime in 1933. Then in 1971, President Nixon took the United States off the gold standard. This move triggered a high rate of inflation that severely devalued the dollar. In 1974 private ownership of gold was allowed once again, but it could not be used as payment in contracts.
Now, we can both own and pay with gold, but another president could make it illegal again. Thus some people believe you should buy gold now before that happens.
Today, the U.S. dollar is only valuable because the government has declared it legal tender and we act accordingly. The dollar has no intrinsic value and is not backed by any reserves of gold or silver. It is a "fiat" currency. If a significant portion of society ever lost faith in its value, it would no longer be accepted despite government edict. We would experience hyperinflation, and the dollar's purchasing power would fall precipitously.
Historians cite examples of fiat currencies imploding after hyperinflation, making these worries a real concern. Since 2008 the U.S. government has been actively devaluing our currency. Holding interest rates low with quantitative easing has kept inflation higher than normal. Meanwhile the government has kept the official reports of inflation artificially low.
This situation engenders deep concern. The value of gold is heavily correlated to fears of economic or political collapse. It is argued that gold could protect us from such a catastrophe.
This position makes gold a fallback currency, not an investment. The argument against gold as an investment is twofold. First, gold has an expected return that is little more than inflation. Second, gold is extremely volatile.
Expected returns are calculated by analyzing long-term movements in price. Although gold's price is highly volatile, its value averages little more than the increase in inflation.
Jeremy Seigel's book "Stocks for the Long Run" includes the growth of $1 of various investments from 1802 through December 2006. After being adjusted for inflation, gold grew from $1 to $1.95 while stocks grew from $1 to $755,163. At those rates, stocks have an average annualized appreciation over inflation of 6.86%, whereas gold is just 0.33% over inflation.
Gold and silver generally hold their value. They appreciate approximately by inflation. Little or no additional value is added. But gold and silver also rise and fall with global fears. They can be very volatile, even when measured in inflation-adjusted dollars.
Although gold tends to hold its purchasing power, it has not done so for the past 33 years. In January 1980, gold reached a high of $850 an ounce ($2,399 in today's dollars). For the next 21 years the price of gold dropped to a low of $256, losing over 70% of its value. Since bottoming out in 2001, it has regained about half its value.
Gold’s volatility means it has both positive and negative runs. Gold advocates try to make their case based on the positive returns from the bottom of the gold market in 2001 until recently. They ignore the 21 years of decline in favor of the recent 12 years of growth. But any serious analysis for portfolio construction must look at long-term averages.
In 2013 gold is currently trading at $1,368.75. Adjusted for inflation, it has the same purchasing power as it did in 1979. For the past 34 years, gold has just kept up with the official figures for inflation, albeit gyrating wildly above and below the Consumer Price Index.
Long-term averages make gold look like a safe store of value. But if you purchased gold at its height in 1980, you have lost more than half your buying power. In contrast, stock investments since 1980 have increased their purchasing power more than fourfold.
Modern portfolio theory advocates blending asset classes to maximize expected return and minimize portfolio volatility. Portfolios constructed according to these specifications have their risk-return ratio on the "efficient frontier," a curve depicting the best possible risk-return combinations of asset allocations. Assets with low expected returns and high volatility are not part of the efficient frontier.
For any portfolio that includes an allocation to gold, there is a better portfolio, one with a higher expected return or a lower volatility that has a zero allocation to gold. The efficient frontier teaches us that the optimum allocation to lower performing, higher volatility investments is zero. Therefore, the optimum asset allocation to gold over long periods of time is zero.
Gold is not an investment. It is better described as a store of value. We use the term "investment" to describe something that pays you money. Stock ownership is an investment because it has earnings or at least the hope of future earnings. Bonds pay interest. Rental properties collect rent.
Using this definition means many items of value are not deemed investments. For example, a fur coat, original artwork, or comic book collection are not investments. Neither is a beach house reserved for private use. These items all have value. Some of them may even appreciate at a rate greater than inflation. But as a whole, they have an expected appreciation that is little more than inflation.
A wise rule is to opt only for investments. Gold is a safe store of value but not an investment. Cash isn't a safe store of value. When adjusting for inflation, $1 has dropped to just $0.06 in buying power over the last 200 years. Cash doesn't pay you money and is not an investment. The correct asset allocation to dollars is also zero.
Holding physical precious metals may be useful at times, but it is a mistake to purchase gold for its investment potential. The diversification of modern portfolio theory does not mean buying a little of everything. Rather it means finding the most efficient blend of assets to provide the best chance of meeting your long-term financial goals.
The optimum allocation to gold is always zero because its return is too low to be a real investment and its volatility is too high to justify its low return. If you choose to purchase gold, limiting it to less than 3% of your portfolio will protect you from compromising financial goals that depend on appreciation above inflation.
Great article, just great.
Posted by: Mert | June 08, 2013 at 06:11 PM
Gold does not compete with other investments like stocks. Instead, gold competes with cash and has always outperformed cash over the long run. Given that investing in the stock market right now is extremely risky, gold is a much better option.
Posted by: Timmy | June 10, 2013 at 07:40 AM
Find common ground and buy gold mining stocks! They are extremely volitile though, but provide exposure to gold and invests in a company.
Posted by: Dave | June 10, 2013 at 11:48 AM
The key phrase from this article that I have always said of gold is that "it is not an investment"
Investments pay you money. Gold just sits there.
You may think gold is a smart thing to buy. You may be right. That doesn't make it an investment.
Valid arguments about gold cannot use the word investment.
Posted by: Apex | June 10, 2013 at 12:24 PM
So Gold is better than cash. We all should have some cash in our asset allocation. Does that mean we should convert all our cash to gold?
We don't have any gold at the moment.
Posted by: Retire By 40 | June 10, 2013 at 01:37 PM
@Retire By 40,
Cash in an asset allocation is not there as an investment option. I don't necessarily subscribe to the view that there should be any cash in an investment allocation but if it's there it's for liquidity. Gold would not be a good substitute for liquidity.
Posted by: Apex | June 10, 2013 at 02:25 PM
You buy physical gold so you can trade it for food, firearms, or a ticket out of the country if things ever hit the fan.
That's it.
It's insurance. Everyone should own some.
Posted by: Eric | June 10, 2013 at 07:04 PM
I'm not a gold bug by any stretch, but this article cherry picks selected data that doesn't make a coherent story. The author uses 1979 and 1980, at the height of what was clearly even at the time a gold bubble to show a lack of return. It's like picking March of 2000 for the Nasdaq and arguing that you shouldn't consider stocks an investment because we've never made it back there. He also uses a 200 year timeframe even though for the first 100 years of that the dollar was largely stable as it was fixed to gold.
Looking at gold since Bretton Woods dissolved in 1971 and the CPI since the Fed was created in 1913 tells a very different story. A dollar held since 1913 would buy you 4 cents worth of things today. An ounce of gold bought in 1971 would have returned substantially in real terms.
The dollar will not hold its value in the future, and it cannot given the amount of debt the U.S. will have to inflate away. There isn't a conspiracy here, but it's basically in no one's best interest (save for pensioners and consumers that like imports) for the dollar to hold its value. The Fed explicitly targets reducing its value, Congress loves it when it gets its free lunch via inflation, and those two forces combined guarantee the dollar will keep losing value year after year.
The article does correctly point out that gold has and will continue to fluctuate wildly, but I'd be interested to hear an argument that an ounce of gold will buy many fewer dollars 10 years from now.
Posted by: CD | June 10, 2013 at 09:49 PM
@Eric,
If things hit the fan such that you really badly need food, firearms, and a ticket out of the country, please do tell me who in their right mind is going to trade those things to you for a worthless lump of yellow rock that they cannot do anything useful with?
There are some decent arguments for owning gold and some bad arguments for owning it. The "hit the fan" argument is about as bad as it gets.
Posted by: Apex | June 11, 2013 at 12:04 AM
@CD,
You are guilty of cherry picking as well. You want to pick 1971 so you can start gold at $35 an ounce at the latest point possible. But the price of gold had been fixed by the gold standard at $35 an ounce since its inception. Inflation still happened in the wake of the gold standard. You can easily google US inflation and pull up a graph that will show wild fluctuations in the price of goods even as we were on the gold standard. So the gold standard did not stop inflation, and yet the price of gold in dollars was fixed. That kept gold at an artificially low price while everything else inflated. When the Gold standard came off Gold sky rocketed and overshot it's fair value and headed up to $800 an ounce and then dropped back into the $300 range.
To say gold was truly worth $35 an ounce in 1971 and then use that to suggest that gold beats inflation is not remotely accurate. You cheated in the same way you accused the authors of the article of cheating.
Over time Gold is likely to approximately keep up with inflation as are most hard assets. But some assets get you a return, such as real estate or stocks. And they also appreciate with inflation.
Why people want to use gold as a store of value when they could use something that will appreciate with inflation and give a return while you wait is a constant mystery to me. I guess there is just something magical about the allure of a yellow rock. I have not rubbed on one and gazed deeply into my reflection while holding a bar of it so perhaps I have just failed to appreciate its magical powers yet.
Posted by: Apex | June 11, 2013 at 12:12 AM
The funny thing is that having coins made of actual gold doesn’t completely prevent hyperinflation, either, because historically, governments have dealt with tough times by deliberately debasing the currency—typically, they’d require all taxes to be paid with old coins, would melt them down, and would make all payments in new coins with only 80% or 90% the amount of rare metal in them. The result could be massive inflation due to the government “printing” money arbitrarily over time. (Striking it, more accurately.) (Byzantine Empire, I'm looking at YOU!)
Posted by: Jenny @ Frugal Guru Guide | June 11, 2013 at 07:34 PM