“Gold Continues to Break Records.” “Gold Hits $1,217 an Ounce.” “Gold Futures Soar 37%. This Year.” Gold is getting plenty of attention from the popular press and performance chasing investors. As if outperforming all major asset classes over the past few years wasn’t enough to spark interest in the commodity, the looming specter of inflation and a declining dollar have prompted many of the talking heads on CNBC to trot out the old advice to buy gold as a superior portfolio hedge.
I’m no gold bug. In my view, gold is a luxury commodity, not an asset class. With neither a coupon rate nor growth prospects, gold can rise in price only as much as demand for it grows. Accordingly, gold has no place in a properly diversified portfolio.
As Warren Buffett once quipped, “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Remember, too, that gold no longer functions as a cash equivalent. The United States abandoned gold as the foundation of its monetary system and moved to a fiat, or paper, currency with two major policy decisions. First, in 1933, President Franklin Roosevelt ended Americans’ right to surrender paper dollars for gold and even to own gold bullion. Then, in 1971, President Richard Nixon “closed the gold window” and denied foreign governments the right to turn in paper dollars for gold.
Even so, investors looking for a hedge for inflation often will settle on gold. Why? Most of the time, as inflation increases, the price of gold goes up, too. Since the end of World War II, U.S. inflation was at its highest in 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33 percent, whereas the average real return on gold was 130.4 percent. However, there are problems with relying on gold alone as a hedge to inflation. Specifically, from 1980 to 2001 when prices in general doubled, gold’s price fell from $850 to $257 per ounce.
Simply, the relatively high volatility of a tangible asset like gold is a major reason it fails as an inflation hedge. And gold’s current high price creates additional risk for those investors who, unlike me, would make a tactical move into gold. It’s worth cautioning these performance chasers that gold last experienced a run-up similar to its recent rise in the late 1970s, and its price declined more than 50 percent in the two years that followed.
As I’ve said before, we can best manage the threat of inflation by staying on the shorter duration end of fixed income securities, particularly as our national deficit and supply of Treasury bonds increase. Treasury Inflation Protected Securities (TIPS) also are likely to be superior to gold as inflation hedges.
Remaining diversified with exposure to stocks is also crucial to protecting your purchasing power. While rising inflation can hurt corporate profits in the short- term, companies have pricing power of their products and when inflation hits, they can raise prices to maintain their profitability. Accordingly, inflation often has a neutral effect on stocks.
Of course, if you own gold, I’m not suggesting you sell your collectibles. Remember, however, that we never recommend keeping gold without insurance. If you are currently uninsured, you can purchase insurance on your gold as part of your homeowner’s insurance. Also, keep your gold in a fire-proof that is heavy enough that it cannot be carried away. You might also carefully consider the location of your safe as it is always unwise to advertise your valuables.
To sum up, gold is not an asset class and, therefore, not part of our diversified portfolios. Further, particularly in today’s transitioning market, the most prudent investment approach is to focus on what we can control, i.e., maintain a disciplined asset allocation, utilize low-cost investments, and own a diversified portfolio. Although gold’s recent shining performance may catch your eye, broad diversification among traditional asset classes remains the best strategy to achieve your long-term goals.