posted on December 18th 2016 in Austin CFP Team Posts & Your Financial Advisor with 0 Comments /

Political upheaval, inflation pressure and uncertainty of global norms have recently resulted in a glitter on gold. Furthermore, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) finally approved its new Shari’ah standards on gold, potentially opening up gold as investment for an additional 1.6 billion Muslim investors heretofore not able to invest in it due to religious law.

Now, of course, the sales folks are everywhere on the radio, on the Internet, at your local brokerage shop insisting that gold is a necessity in your portfolio.

So it’s time to buy gold. Right? No, not necessarily.

First, let’s do away with this idea that there is a unique opportunity as a result of the AAOIFI announcement. Unfortunately, like most “opportunities,” the market reacted early and quickly to the possibility of these new standards and because of this and other factors, the price of gold peaked months ago in June 2016 and has since dropped approximately 14% to the time this being written. Like most “opportunities,” it is extremely difficult to beat the collective knowledge already reflected in the pricing of assets you may be looking at in the global markets.

Second, let’s look at the reality of investor return on gold.

  1. No Investor Could Have Realized The Actual Long-Term Performance of Gold. Much of the robust appreciation of gold occurred under special circumstances in which U.S. investors could not benefit directly. Here’s why: In August 1971, President Nixon took the U.S. off the gold standard, and the price was reset to $38 an ounce. In 1973, the U.S. government decoupled the dollar’s value from gold, and the price was allowed to float freely. During 1974, the price of gold quickly shot up to $120 per ounce in the free market. Beginning in 1975, the government removed ownership restrictions and U.S. citizens were free to directly own gold for the first time since 1933. So, U.S. investors could not participate in gold’s price appreciation during the first half of the 1970s, and if you disregard those early performance years, gold loses much of its glitter.
  2. Gold Underperformed vs Other Asset Classes. Since this special circumstance (that you couldn’t even participate in) is not expected to occur again, don’t be fooled by gold performance data that includes the 1971-1974 time period. If you disregard that period when U.S. investors could not own it directly, gold’s long-term performance drops substantially. From 1975 through 2011, gold produced a real annualized return of only 1.82%, while U.S. small cap stocks returned 10.6%, the S&P 500 returned 7.1% and non-U.S. stocks returned 5.5%. So, from a long-term perspective, gold has not experienced a reliable or   sustained rise in value. In fact, its price appreciation has been limited to unpredictable, isolated episodes of high demand. Investors who attempted to time these episodes exposed their wealth to potentially higher risk and to the opportunity cost of missing out on stock market growth.

Gold as a Portfolio Diversifier

Proponents also claim gold offers a portfolio diversification benefit due to its low historical correlation with stocks. This may be true when gold is held as an incremental part of a broader diversified commodity strategy within a portfolio. But correlation is not the only factor to consider in diversification. Volatility also matters, and history shows that while gold has a long-term return similar to the S&P 500 Index, its volatility approaches that of U.S. small value stocks, an asset class that historically has demonstrated a higher average return for the higher risk. So, holding gold as an asset class can make a portfolio considerably more volatile, which may offset the potential benefit of low correlation.

Also, according to modern financial principles, the components of a portfolio should have an expected return. As a material input, however, gold does not offer the potential for generating income or earnings. Its only source of return is price appreciation caused by shifting supply and demand, and price appreciation is not a certainty.

These characteristics make gold a speculative asset, like currency or collectibles. If you put gold in a vault and wait a few decades, it will not produce anything, and its value will reflect the current spot market price. In fact, holding physical bullion may incur negative cash flows due to storage, insurance and other costs. In contrast, a stock reflects ownership in a business enterprise that seeks to generate profits and produce more wealth. Investors who put their capital to work in the economy expect a potential return from cash flows and appreciation.

With regard to having a successful experience investing in gold, an old adage may apply here: “You can’t polish a turd, but you can roll it in glitter.”

Sources for all figures: CRSP data provided by the Center for Research in Security Prices, University of Chicago; the S&P data are provided by Standard & Poor’s Index Services Group; securities and commodities data provided by Bloomberg; MSCI data copyright 2012, all rights reserved. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money. The indices are not available for direct investment. Performance does not reflect the expenses associated with the management of an actual portfolio.

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