Never mind the other excuses, what about gold as an investment?
Whenever an investment has had a good run-up in prices, a controversy develops about whether the high returns will continue to roll in or it’s a bubble that’s due to pop. Spurious arguments about inflation-hedging and currency-hedging aside, investors are delirious about gold because they’ve seen the price zoom up in recent years, and they are experiencing regret and a desire to relive history and invest right this time. This is what keeps bubbles bubbling and momentum surging. In the end, however, it’s a game of chicken or the greater fool theory – momentum will guarantee that I can get out at a higher price than I got in; except when it doesn’t, and the pop occurs faster than I can get out.
“Gold is under-owned” is one of the arguments for continued upward momentum. The value of gold held by private investors is about 2% of the aggregate value of stocks and bonds, but most investors – such as institutions – have nowhere near 2% of their portfolios in gold, since a subset of investors hold a disproportionately large amount. The argument is that they therefore under-own it, and once there is a general realization of this under-ownership, and a scramble to buy more, the price will surge upward still further. Better to be first among those to ramp up their ownership, the reasoning goes.
On the other side of the debate – the side that anticipates a gold price collapse – is the “reversion to the mean” argument. History shows, according to Erb and Harvey, that if gold were to revert to its normal price in the next 10 years, the return on holding gold will be roughly negative 6% per year. The history of mean reversion, however, is built largely on a single price spike incident in 1980, after which the next 10 years’ annualized return was negative 6%. So there is little solid proof that gold’s price will either continue to rise or that it will fall.
What can be said with certainty, however, is that investment based on the theory of momentum is inherently very risky. It is like always depositing your money in the bank with the highest interest rates but the shakiest credibility. You are constantly at risk of a run on the bank, and cannot rest easy, unless you believe in your ability to run to the bank faster than anyone else.
The risk of hyperinflation
Each time Erb and Harvey take up the argument – or its surrogates – that gold is a hedge against inflation, they consider that what might really be meant is that gold is an insurance policy against the highly improbable, but severely damaging, scenario of hyperinflation.
Gold ownership would make sense as a hedge against hyperinflation, if after the bout of hyperinflation the gold could be cashed in for a reasonable quantity of the eventually stabilized currency. In a hyperinflation regime, not only gold but any goods are better than holding cash. Brazil’s hyperinflation of 1989-93 was linked to a surge in rainforest destruction, because wealthy Brazilians cleared land in order to deposit their wealth in a stable-valued asset, grazing cows.
Cows may not hedge very well against millennia of inflation, but Erb and Harvey show convincingly that in most other respects they are no worse an investment than gold. Plus, unlike gold, if you can’t cash your cows in, you can always just eat.
About The Author
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment and sustainable development fields. He is a Visiting Fellow at the Hong Kong Advanced Institute for Cross-Disciplinary Studies, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.
