More and more people want to know if they should buy gold today, so I ask the question: why do you want to own gold?  Simply because it has gone up in value doesn’t make it a good investment today.  Although most individual investors would never admit it, this is exactly the reason they are intrigued by gold’s prospects.

What’s strange is that people tend to reduce their consumption of goods like gas or clothing when prices rise, but the opposite seems true with financial assets.  People are more attracted to a stock price that has risen because we incorrectly apply past price changes into the future.  (For more about behavioral biases, click here.)

There is merit in using gold to bet against paper currencies, particularly the dollar and euro, but it is extremely difficult to derive gold’s value for investing (notice that I differentiate bet and investing).    With stocks, you can look at the P/E ratio and free cash flow to reach some conclusion about potential returns.  With bonds, yield to maturity and duration allows an investor to approximate future returns.  But gold doesn’t generate earnings or income, nor can you generate an expected return.  This could be the reason that gold hasn’t offered a real return over the past 30 years.

If you had invested $1.00 in gold in January 1980 (gold was then at an all-time high of $850/ounce) and held it through August 2011 when prices reached roughly $1900/ounce, your investment was worth only $0.99 on an inflation-adjusted basis.

From this example, one can easily make a case for gold as a hedge against inflation.  I’ve written before about preferring TIPS as an inflation hedge due to its lower volatility and similar returns to gold.  Even more, gold’s correlation over the past 41 years with U.S. Consumer Price Index (the broadest measure of U.S. inflation) has been only 0.11, which is awfully low.  (To learn about correlation, click here.)

Speaking of correlation, a common argument for allocating a portion of your portfolio to gold is its low correlation to stocks, but this fact alone is not sufficient to justify adding gold to your portfolio. For example, the outcome of bets on football games has no correlation with stock market returns, but that doesn’t mean betting on sports should be a part of your investment portfolio.

Today’s gold prices reflect a lack of trust in paper currencies (or the governments backing them) as well as historically low interest rates.  When short-term interest rates are near 0%, the opportunity cost is quite low and speculation in any asset is more attractive – the purpose of the Fed’s interest rate policy is to get people to take more risks.  That said, gold has large downside risks in a rising rate environment; and at today’s prices, gold does not compensate investors enough for the risk they are taking.

Peter Lazaroff

St. Louis, MO

http://www.acrinv.com/