The Case for Investing in Gold

The last two years have been disappointing for gold investors and what happened this week to the yellow metal epitomized the frustrating price movement. After the Fed startled the markets by announcing that it was going to continue with its current rate of bond purchases, gold shot up from just under $1300 an ounce to $1370. But late Thursday, it started to back off somewhat from those gains before falling sharply on Friday.  It ended the week at $1325, virtually unchanged from the prior week.

How can that possibly be?  It has, after all, become more evident that the Fed is politically hindered from turning off the money spigot. If gold can’t stay elevated on that development, what hope is there going forward that it will resume its decade-long uptrend and eventually overtake the  2011 high of $1900 per ounce? And so why bother investing in gold?

Yet the case for investing in gold does not depend on the market’s reaction to the Fed’s latest doings. For a trader in gold — someone looking to profit from taking a position over a period of days or weeks — it certainly would.  An investor, by contrast, has a longer time horizon — years, if not decades. For the investor, whether or not to buy gold necessarily entails forming a judgement about the larger and more enduring forces that impinge on its price. Is our politico-economic system, in other words, congenitally disposed to the cheapening of the currency?

Those who invest in gold basically answer yes. And they have very solid grounds for that stance. In the democratic polities that prevail today in the developed world, politicians have very strong incentives to run budget deficits. For the way to maximize votes is to spend money on benefits for the public and then to simultaneously minimize the taxes levied to fund those benefits.

Propelling this dynamic along is that the economies of developed nations have liquid bond markets in which government debt securities, whose safety can be believably affirmed by the state’s power to tax,  are eagerly sought by risk-averse investors. In this way, the bond market greatly relaxes budgetary constraints on politicians, being equivalent to a payday loan provider that ensnares a spendthrift individual into amassing a huge debt.  When this debt becomes unsustainable, and the bond market finally acknowledges the mess it enabled, politicians must decide between imposing fiscal austerity or printing money to pay off the debt. The latter is the politically more attractive option, especially as the resulting inflation can be blamed on private industry. The recognition of this inflationary tendency built into our politico-economic framework is what constitutes the case for investing in gold.

Nor is this all just idle theorizing. The logic of a democratic inflationary bias is well illustrated by the historical experience since August 1971. This is when the last remnants of an external constraint on money supply creation was done away with by President Nixon’s closing of the gold window. Before then, the U.S. government stood ready (at least vis-a-vis other central banks) to exchange dollars for gold at $35 per ounce. How would someone, aware of the long-term inflationary threat that Nixon’s decision posed, have done had they invested in gold at the time and held it until now?   The answer is that they would have generated an 8.7% annualized rate of return.

Compare that to investing in stocks. Let’s say you invested in the S&P 500 index over the same time frame. Now one big difference between investing in gold and stocks is that the latter pay dividends. So to make our comparative test of gold even stronger, let’s assume one reinvested the dividends in the S&P 500. How much would such an investment in the S&P 500 have returned? The answer is 10.2%. Yes, that’s 1.5% more than gold, but with shares one is actually betting on a group of private companies’ ability to generate profits. With gold, one is simply looking to preserve purchasing power over goods and services. To have only sacrificed 1.5% for this more modest aim has arguably been a good deal.

Or let’s pit gold against government bonds. What we are comparing here is actually closer. Like gold, government bonds do not involve a play on future company profitability.  Their yield is supposed to cover the time value of money as well as compensate for expected inflation. So how would an investment in 10 year US treasury securities, with a reinvestment of their coupon interest payments, have performed from 1971 until now? The annualized rate of return was 7%. That’s 1.7% less than holding gold.

annualized-returns

Over the past forty two years, one would have been better off holding what Keynes called the barbarous relic than what are commonly described as the safest securities in the world. Unless there is a tectonic change in our politico-economic structure — such as a return to a hard money standard — it’s hard to see how this will change.

10 Responses to “The Case for Investing in Gold”

  1. Gold is something that's worth spending your money because it's a great investment and assets. One of the reasons people invest on good because they see that the dollar is decreasing its value in the market.

  2. Very impressive article. The information is very useful. Keep up the good work.

  3. Lee says:

    Fascinating post! I think it illustrates well the long term potential of gold, and the need to ride out the rough waves of the present.

  4. chris says:

    or perhaps, as the article points out above, the intent is not investment, but savings. safety of principal, inflation-adjusted, not proactive amalgamation of wealth.

  5. Tomas Salamanca says:

    In response to Realaustrianbybirth, let me point out that 1971 was picked because it was most germane to the thesis put forward for investing in gold — namely, that governments entirely unshackled to produce as much money as they see fit will inevitably oversupply the economy with its money and so devalue it versus gold. As that unshackling began in 1971, that is the best starting point from which to test my investment thesis for gold. I would also reiterate Irwin's observation that one cannot simply "cherrypick" time frames to make the case against gold or any other investment for that matter. To deal with this cherrypicking issue, it is best to calculate rolling returns over, say, 5, 10, and 20 year holding periods from different annual starting points. In a future post, I will endeavor to do that.

    • beholder says:

      i look at it this way. I am 72, retired and funding that retirement with social security, a small union pension, and some dividends from a few stocks, which puts me in a modestly comfortable position. 1971 just about coincides with the beginning of my investing life, as I hardly made more than my expenses through my early working years. So this study represents the entire reality for a good many Americans. I don't truly think it is cherry picking to take a forty plus year cycle in which conditions were put in place that an earlier investing period did not represent in order to offer a clear picture of the nature of three major investment vehicles and their comparative returns. The only omission, which might change the picture, was not to have included real estate in the comparison.

  6. vic says:

    so it's all about timing

  7. Realaustrianbybirth says:

    This is a misleading article, as it seems to take the then artificially fixed price of gold at $ 35 as a viable starting point for the timeframe which it is not.
    Or let´s have a look at the gold chart from the mid 80ies until around 1999 which was quite a disaster from an investor´s point of view, as it has been again since 2011. Also, no one with at least some basic investing knowledge would stay in the stock market during 40 years without any action – buy low, sell high is what you do with stocks. Even if this does not work all the time for everyone, this is nevertheless what you are supposed to do as a shareholder from time to time in order to optimize your investment. One could argue about the reasons and implications of the phenomenon, but if you start your outlook with 1971, the stock and real estate markets offered much better, and, above all, more and more frequent investing opportunities than gold.

  8. olduvainovel says:

    I like what Kyle Bass of Hayman Investment says about gold: "Buying gold is just buying a put against the idiocy of the political cycle. It's That Simple."

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