WITH STOCK PRICES so high and interest rates so low, many folks are thinking about buying gold. Tempted to take the plunge? Ponder these nine issues:
1. No income. Gold pays no interest or dividends. That means gold’s return hinges entirely on its price going up. Gold ownership also means you must forgo the interest and dividends you’d have otherwise earned on alternative investments. Still, with interest rates so low, the opportunity cost of owning gold—at least in terms of lost income—is very low right now.
2. Limited utility. Gold doesn’t have much practical use. According to the World Gold Council, an industry trade group, demand for gold over the past 10 years came from jewelry and technology manufacturers, and from financial customers, such as exchange-traded funds and central banks. Financial customers weighed in at about 50% to 60% of that demand. The upshot: Gold prices depend on these customers buying a product that has no actual utility to them.
3. Valuation is difficult. Gold lacks the fundamentals needed to determine fair value. You can’t discount expected future cash flows, because gold has nothing to discount. Other asset valuation techniques, such as multiples of earnings or revenue, also don’t work. Instead, gold prices fluctuate wildly based on short-term supply and demand factors, including production levels, discoveries of new reserves, central bank actions, and cycles of investor fear and euphoria. In essence, gold’s price is determined by what people are willing to pay for it at any given moment.
4. Lackluster returns. Gold began to trade freely in 1971, when the U.S. went off the gold standard. Returns since then haven’t been attractive compared to stocks. If you invested $1,000 in gold at year-end 1971, it would have grown to about $50,000 by year-end 2020. That same $1,000 invested in the Wilshire 5000 total stock market index would have grown to about $185,000.
Gold skyrocketed in the 1970s due to its liberation from the gold standard and unusual economic conditions, notably rapid inflation. If these events reoccur, gold could be a home run again. If not, it could be a drag on investment performance. Suppose we ignore the 1970s and look only at the past four decades. Over that stretch, a $1,000 investment in the Wilshire 5000 grew to some $73,000, while a $1,000 gold investment grew to about $3,000.
5. Stock market hedge. Gold has been a reasonably good way to diversify a stock portfolio’s risk, because gold prices tend to move independently of stock prices. This has been the case for much of the past 50 years, although not so much over the past five years. While we can’t know for sure, gold will likely continue to be a good stock diversifier, and owners may benefit through reduced overall portfolio volatility and gains from rebalancing. The downside: Despite any performance boost from rebalancing, this hedge usually carries a cost—in the form of lower overall portfolio returns, because of gold’s drag on long-run results.
6. Inflation hedge. Gold has a reputation as an inflation hedge, but reality suggests otherwise. There have been periods since 1971 when gold outpaced inflation, but there have also been long periods when it didn’t. Notably, gold wasn’t up to the task during the 30-year period from 1981 to 2010, when it didn’t keep pace with inflation.
Stocks, inflation-indexed Treasury bonds and natural resources do a better job of protecting against inflation. Stocks have delivered significantly higher returns than gold. Inflation-indexed Treasurys have an income stream that is directly tied to inflation. And natural resource prices are more highly correlated to inflation than gold.
7. Currency hedge. Gold tends to be negatively correlated with the U.S. dollar, which means it rises in value when the dollar weakens. A weaker dollar creates an inflation problem for Americans, because it takes more dollars to buy goods and services from foreign suppliers. Some U.S. investors hedge this risk with gold.
But do you really need to? A prolonged decline in the dollar is unlikely. The dollar is the world’s reserve currency, the U.S. is fundamentally sound and our growth prospects relative to other developed countries are favorable. On top of that, as I noted in point No. 6, there are better ways to hedge inflation.
8. Fear hedge. Gold is undoubtedly an effective hedge when people become fearful or major crises arise. Global banking systems are quite stable under normal circumstances, but can become unstable when political, economic and natural disasters arise. Gold exists outside of these systems, so its price tends to rise during turbulent times and fall when conditions return to normal. You can make money during these cycles, but knowing when to get in and out is awfully difficult.
Some people also believe gold will be a valuable currency in a post-apocalyptic world where banking systems have disappeared altogether. But who knows? Gold will only be worth something if the people who own food, shelter or medicine are willing to exchange them for gold. Owners may be reluctant to make that swap if it jeopardizes their own survival.
9. Unfavorable taxation. Gold is taxed unfavorably when held in taxable accounts. Federal and state governments consider gold to be a “collectible.” At the federal level, long-term capital gains on collectibles are taxed at ordinary income tax rates, but with a cap of 28%. By contrast, long-term gains on traditional investments are taxed at 0%, 15% or 20%, depending on your income level.
Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife. Check out his previous articles.
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