HardAssetsInvestor

Written by Larry Swedroe  |

December 22, 2008

As Good As Gold?

Details

[Editor's Note: Brad Zigler is off this week. In his stead, we bring you a variety of voices covering the commodities space.] Whenever equity asset classes experience bear markets, investors seek out safe havens for their investments. This is especially true in times of financial or political crises.

One whose popularity runs in cycles, with short bursts of enthusiasm or "frenzy" as the price soars, followed by long periods of it being ignored, is gold. And while the price of gold has fallen from its peak of over $1,000 in March 2008, we can still say that it is in the "frenzy" stage.

The main argument made by advocates of gold is that they believe that it is a good hedge against inflation. For the period from 1935 (when the price of gold was fixed at $35 an ounce by the Federal Reserve) through October 2008, gold did provide a positive real return of 0.6 %. Unfortunately, not all individuals have horizons of 73 years. We need to consider more-realistic investment horizons. This is especially true for retirees (for whom 73 years would be far greater than their horizon), or those nearing retirement, as they face the greatest risk of inflation negatively impacting their lifestyle. We address that issue by considering the period since 1981 - the last time there was a "frenzy" for buying gold.

In 1979, inflation peaked at a rate of 13.3 %. That was followed by an increase of 12.4 % in 1980. The price of gold rose as the fear of inflation increased. While we admit to a bit of data mining, the following example demonstrates that gold is not a good inflation hedge, unless perhaps your horizon is "infinite."

Let's assume that to provide a hedge against future inflation an investor decides to purchase gold at the end of 1980 with the price at $641 an ounce. Over the next 27 years (1981-07), inflation rose at an annualized rate of 3.4 %. If gold were an effective hedge against inflation, its value at the end of 2007 should have been at least $1,528. Yet, it was worth just $833 (an annualized return of just under 1 %). In other words, an investor in gold experienced a reduction in purchasing power of 2.4 % per annum, or a cumulative loss of purchasing power of about 55 %. For an investor who was unlucky enough to purchase gold at its peak of $850 an ounce on January 21, 1980 (as some undoubtedly did), the inflation-adjusted price would have had to have been in excess of $2,300 by the end of 2008. If gold can provide negative real returns of that size over almost a 30-year period, it cannot be considered an effective hedge against inflation.

Even worse is that our example does not consider the costs of investing in gold. Strategies have no costs, but implementing them does. The most direct way to invest in gold is to purchase actual gold coins or bars, which may require additional transportation, storage and insurance costs.

Another common option is to use the futures market. The problem there is that like all easily storable commodities, gold trades in contango - the futures price is higher than the spot price by an amount equal to the cost of carry (financing, storage and insurance costs). Therefore, over time, the investor, while having the incremental trading costs involved in rolling over the futures contracts as they mature, also has the cost of the contango.

A third way to invest in gold is by purchasing shares of an ETF such as the SPDR Gold Trust ETF (GLD). The fund has an expense ration of 0.4 % (plus the costs of storage, etc.). Thus, no matter the method used to gain access to gold as an investment, the already-poor real returns would have been negatively impacted.

While commodities as a broad asset class (as opposed to gold specifically) are too volatile to act as a hedge against inflation, we believe they are a more superior hedge against inflation than gold. The price of gold itself has very little impact on the economy or the rate of inflation. On the other hand, while a commodity index such as the S&P GSCI does include gold, it also includes a wide range of commodities that can have a significant impact on the rate of inflation (i.e., Energy, Industrial Metals, Livestock and Agricultural commodities). Note that for the period 1981 through November 2008, the S&P GSCI returned 6.7 % per annum, outpacing inflation by over 3 % per annum, and far outpacing the return on gold.

 

Summary

While gold has provided a slightly positive real return over the very long term, the price movement is far too volatile for gold to act as an effective hedge against inflation. For those investors who desire to hedge the risk of inflation, the preferred instrument is TIPS, which directly hedge the risks of inflation.

 

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Larry Swedroe is the author of The Only Guide To Alternative Investments You'll Ever Need, Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today (2002), The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003) and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a principal and director of both Research at Buckingham Asset Management and BAM Advisor Services—a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices—in Clayton, Missouri (www.bamservices.com).