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?
