Money Management and the Economy

Saturday, October 27, 2012

How Safe is Gold?

As often happens when the markets are bouncing up and down, some people are turning to the "safe haven" of gold. But how safe is gold?

Gold has several attributes that make it attractive:

1) Gold is durable. In fact, some of the gold you buy today was probably mined by the Inca's thousands of years ago.

2) Gold is universal. With very few exceptions, gold always has value. This is true historically. And no matter where you go today you can likely trade gold for other goods either directly or by converting it into the local currency.

3) Gold is portable. While heavy, gold packs a lot of value in a small package.

4) Gold is beautiful. You can store it as jewelry or other decorative art.

So if you are looking for an investment that will last a 1000's of years and still hold value, gold is a great commodity. Or if you are looking for something that will be likely to survive a complete societal breakdown like a war. However, when you start to look at likely financial conditions in your lifetime, gold's risks start to come into focus.

Because while gold is durable, universal, portable, beautiful, it will not always have the same value. In fact, the price of gold in dollars (or any other currency) is quite volatile. And its value doesn't just change relative to cash, what you can buy with an ounce of gold varies a lot. You might pay $1700 for an ounce of gold today. Perhaps that would make a down payment on a new car. But if the price falls back to where it was 10 years ago, the $280 you get for your ounce of gold won't be much of a down payment. And if you bought an ounce of gold in 1980, you still wouldn't be able to buy as much as it cost you then relative to inflation despite today's high gold prices.

Of course, if you bought GM stock ten years ago you would have done worse, since it would be worthless today.  So the fact that gold goes up and down in value is not fatal.

The difference is that GM lost its value because it stopped being able to produce cars at a profit, couldn't pay its debts and went bankrupt. Gold loses or gains value based solely on changes in how much the people who want to buy it have to pay to find a willing seller.  The gold itself never changes. The gold remains the same durable, beautiful lump.

This is the difference between investment and speculation. Investments are like planting a tree or purchasing fertilizer to make it grow. You expect a return because the investment leads to more production that has value.  Of course the plant might die and you get nothing in return.

Speculation relies on buying low and selling high.  For you to buy low, someone else has to sell low. And to sell high, someone else has to buy high. In the case of stock, the value might have changed based on economic conditions or growth in the company. You are still speculating, but your money is working to make the company more valuable. Its like a mature tree. The company stock is more valuable because the company is more productive. Meanwhile, the gold still remains the same durable, beautiful lump.

So why is gold approaching a record high? Why are people willing to pay more for it now than they were ten years ago? It seems many gold investors believe we have inflation in our future and others are afraid of other investments after having been burned in the stock market and real estate.

In theory, gold can be a hedge against inflation. As the price of other things raise, gold will raise along with them. Unfortunately that theory doesn't really appear to be how gold prices respond. It probably explains part of the price, but it doesn't explain gold's extreme price fluctuations. We have had a run up in the price of gold over the past decade despite low inflation. And gold prices crashed even when inflation was higher than today.

Today's gold price is six times what it was a decade ago. Total inflation over that period has been about 20%, one 30th of that. Assume that the long-term price of gold relative to other goods and services should be the same as it was a decade ago. The cost in dollars of everything else would have to go up to 6 times just to sustain the current price of gold.

Far from being a safe investment. Gold is always a highly volatile, speculative investment. You are hearing the same reassurances from its promoters you heard during the bubble and the housing bubble. Gold prices don't go up endlessly any more than housing prices do. Right now it looks like the next bubble. And folks who buy high now will end up holding the bag when the bubble pops.

You aren't smarter than the market. It really is that simple.


Ross Williams said...

Update: In the year since I wrote this article the price of gold has dropped 25%.

Ross Williams said...

Update: The price of gold ended 2012 when I first published this at $1664/oz. The price now is $1267/oz