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Is gold a good long-term investment?

Posted by admin on July 23, 2009 in Investment Products, Investment Strategy

The price of gold and its perception as an investment by bloggers seems to have an inverse relationship. As the price of gold rises, bloggers seem less enthusiastic about gold as an investment. Why such a negative attitude about something going up in price?

Gold, unlike silver or copper, has no industrial usage. In fact, other than for purely cosmetic purposes,  it has no utility which could at least justify an inherent floor price of the commodity. Having said that, gold is the closet thing to a universal currency. If you were in the Republic of Benin, you would most likely get room and board with physical gold; I am not as sure if you tried to pay with USD you would have the same success (especially lately). Obviously, there is also a huge market for gold in the jewellery industry and it is a highly desired luxury for most cultures.

However, it is the concept that gold is a universal currency that makes it, in some respects, better than a money market fund as an investment. When paper currencies that the developing world recognize as the standard falters (i.e. the USD), the markets rush to gold since its underlying value is not dependent on policy decisions of governments or their relative solvency.  As confidence wanes in paper currencies, governments typically resort to printing more of it which only accerlerates gold’s demand since you now have inflationary pressures on paper currency as well and gold is a good hedge against inflation (see below).

The end result is that, in bad times, gold serves as an able substitute for cash. As Jeremy Siegel found, a $1 invested in gold in 1802 would yield $32. 84 in 2006. It serves to protect the value of the $1 invested which, if kept in cash would be worth considerably less than $1.00 due to inflation. But as Siegel also points out that is all gold is: a good protection against inflation.  But, the opportunity costs of investing in gold long-term in lieu of other investment classes is enormous.

Like everything else in investing, gold has its time and place. I would not dismiss the fact it has no utility as a reason not to invest in it. Whether most of us like it or not, I call gold the irrationality hedge. The more irrational the markets get, the better gold is a hedge against such irrationality. The extreme example being times of war. What are governments doing in war? Most are stock-piling or stealing gold from where-ever they can get it.

Does this defy some well-reasoned argument why anyone would want to invest in a commodity that really does nothing other than look pretty? Of course it does but is the market that rational? I suspect the last 9-12 months is a walking argument that the market is not rational.

However, when such irrationality ends (and it always does), one should move out of gold. It is, and should be used, as nothing more than a short-term cash substitute and a hedge against inflation.

The argument that anyone should have substantial portions of their portfolio in gold defies any type of long-term prudent portfolio management. If the world is so bad that gold prices are astronomical, does the size of your portfolio really matter compared to, say, imminent threat of physical harm to one’s self and their family? Investing vast percentages of your net worth in gold long-term due to impending economic armageddon misses the practical point that a net worth calculation probably doesn’t matter anymore when your primary need is survival and self-preservation.

At the end of the day, substitute cash for gold. You would only hold cash/gold in your portfolio in the short-term and during times of uncertainity. Holding a large portion of it or holding it in the medium and long term will generally not serve a prudent long-term investor well.