Executive Summary
If there’s one new asset class that seems to have truly caught the imagination of clients, it’s gold. Technology, real estate, and emerging markets have all caught fire for some period of time in recent years, but gold still seems to stir something emotional in us, above and beyond just the pangs of greed that have characterized the other hot investments of the decade. Perhaps it’s the fact that gold is something that theoretically performs well in times of distress; it can serve as a hedge in times of inflation, help protect against the declining value of our currency, and be a safe harbor when everything else is in trouble. Given so much client anxiety about today’s economic environment, it’s not difficult to understand the appeal. In the end, there is perhaps only one significant problem: gold doesn’t actually have any value; it can only accomplish these financial feats of strength because we believe that it can.
The inspiration for today’s blog post comes an excellent recent investment memo written last month by Howard Marks of Oaktree Capital Management. In the memo, Marks explores the frenzy in recent years about gold, and some of the discussions for and against the use of gold in portfolios. (Editor’s Note: If you have a little time, check out Marks’ full memo "All That Glitters"; it’s a very well-written perspective on this controversial issue!)
Certainly, most of us have heard the “good” news about gold: it’s a reliable store of value that can serve as an inflation hedge; its supply is finite thanks to the laws of nature, so it can’t just be printed and debased like so many paper currencies; and it is physical and tangible, something you can see and touch and hold, that can’t just disappear like the value of an account printed on a computer screen.
But Marks does an excellent job of also summarizing some of the real concerns about gold, most notably the fundamental fact that it does not actually generate any cash flows or other output that helps to determine intrinsic value: its price, for better or for worse, is only determine by what buyers and sellers are willing to pay at a given moment in time. Of course, the idea that an investment is only worth what buyers and sellers are willing to pay is not new, and is true for the most part for any investment.
Nonetheless, the situation is different with gold. With an ongoing company, some level of profits are produced; real estate generates rental income; bonds generate interest payments. While we may adjust the principal value of a security based on the level of interest rates, capitalization rates, discount rates, some views about potential growth or decline of those cash flows, and some risk that the cash flows might simply cease (e.g., the tenants vacate the building or the company goes out of business), we still have financial metrics that we can use to make a reasonable determination of value. In fact, if the price that buyers and sellers are willing to pay materially deviates from this measure of intrinsic value, a buying or selling opportunity is created for the savvy investor.
Gold, on the other hand, has no such benchmarks. What makes gold a good deal at $500/ounce or $1,000/ounce, fairly valued at $1,300/ounce, still a reasonable opportunity at $2,000/ounce, but “too expensive” at $5,000/ounce? Nothing, but the belief of the markets that those are or are not reasonable prices. If I hold the gold for a long time, it won’t produce more gold income for me; I only receive value because someone else decides they are willing to pay more. Nor does the gold create anything tangible for me; it won’t turn itself into food, water, clothing, or shelter… unless someone else decides to buy it from me and is willing to pay me.
This doesn’t necessarily make gold a “bad” investment. The investment community does hold certain beliefs about gold and its ability to serve as a store of value, and as long as everyone believes that to be the case, it will continue to be true. Thus, ironically, the greatest risk to a decline in the value of gold is not any decline in its intrinsic value (since it doesn’t really have any intrinsic value that can be quantified). The greatest risk to a decline in the value of gold is a loss of faith that gold will continue to maintain its value. A bar of gold can’t go bankrupt; the gold dividend can’t fail to be paid; the gold interest payment can’t be defaulted upon. But if no one is willing to acknowledge gold as a store of value, it has none.
So the next time you’re considering an investment in gold, at least be certain to understand and appreciate that the only reason it has value is because we all agree that it does. Of course, as Marks points out, gold has held this belief position pretty firmly for a few thousand years of commerce, so it’s unlikely to spontaneously fall apart anytime soon. But nonetheless, it’s important to be cognizant that gold is subject to some pretty unique risks, because its value is predicated not on anything intrinsic or innate, beyond our simple belief that it is valuable.
So what do you think? Do your clients view gold as a safe investment, or a risky one? Is gold a store of value, or just a store of beliefs about value? Do you view gold in a different manner than other investments that do produce some form of cash flows?
Gold, while emotionally attractive as a hedge against inflation, is just another asset that can be used as an inflation hedge and like any investment it is possible to overpay for it and lose money. A better inflation strategy would be to buy the value-priced components of a basket of assets, whether it be industrial commodities, stocks, real estate etc. In other words refuse to buy any alleged inflation hedging asset unless it is at a discount and also has some sound value such as a quality large cap equity as opposed to a shaky small cap stock.
By buying an asset that is hard to value because it has no income stream and is subject to arbitrary and capricious whims of investors and governments one must demand a greater risk premium by only buying it at a deep discount; thus gold is actually riskier and on a risk-adjusted basis has less value than other inflation hedges.
Also, I prefer to buy unattractive counter intuitive assets. Since gold is intuitively seen as an inflation hedge that increases the odds that people will overpay for it.
I have nothing to add other than the following quotes:
“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
– Buffett
“I like understanding what works and what doesn’t in human systems. To me that’s not optional; that’s a moral obligation. If you’re capable of understanding the world, you have a moral obligation to become rational. And I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.”
– Charlie Munger
Interesting and true statement that it is a store of value because we say it is. Two thoughts. First, a better store of value if the world falls apart is – lead. Lead is a perfect medium of exchange. I can trade you for some bread and water, or if you aren’t playing nice, I can simply take your bread and water. Can you do that with gold? NO. Second, our fiat currency system works because we all “believe” a dollar has value. Forget that it fluctuates. It has value as a medium of exchange because we all agree it does – and it’s a hell of a lot easier to carry around than gold. Gold is a fiat store of value precisely because we say it is. Hmmmm.
VG,
It’s worth noting that there is one substantive difference between gold and paper currency in this context: we can print more paper currency. We can’t make more gold (although we can try to mine for it in some amount).
This serves as a constraint about how much you can debase gold’s store of value function, at least relative to paper currency.
well written post; thanks for the good work.
I analyze gold as insurance here
http://timelyportfolio.blogspot.com/2010/12/goldcrb-monthly-area.html and http://timelyportfolio.blogspot.com/2011/01/more-on-gold-as-expensive-inflation.html
That’s all well and good, but Gold can play a very useful roll in reducing volatility within a balanced and diversified portfolio. Take for instance the Harry Browne Permanent Portfolio, which calls for putting all of your “safe” money into 25% Stocks, 25% T-Bonds, 25% Gold and 25% Cash. The investor rebalances the money back to 4×25% when any asset grows to 35% of the portfolio or shrinks to 15% of the portfolio — a natural rebalancing of assets based on the free markets response to inflation (gold), deflation (T-Bonds), prosperity (Stocks) or recession (Cash).
You would think that this portfolio wouldn’t do all that well over the long run, but in fact it provides very steady returns with extremely low volatility. Here’s a chart of the Total Real Return of a 4×25% Permanent Portfolio over a 40 year period:
http://goo.gl/YK5hC
The point isn’t so much that the returns are stellar. The point is that the returns are steady and manageable — even during terribly markets. Gold can play a very important roll in a portfolio if you don’t know what’s going to happen in the future. And since no one knows what’s going to happen in the future, it can make a lot of sense to hold some gold and rebalance in and out of it according to your portfolio’s balancing bands.
You can quantitatively value gold as an inflation hedge using actuarial methods such as insurance companies use to value premiums according to assessed risks. You can use the following online calculator to come up with a fair value of gold based on your own inflation expectations:
http://passantgardant.com/blog/61-gold-value-calculator
Likewise with silver:
http://passantgardant.com/blog/66-silver-value-calculator