The Gold Bubble

In recent times, if you compare the past returns of different categories of mutual funds, Gold ETFs are at or near the top at almost any point over the last three years when compared to equity funds. Through the financial crisis and later, the best way to maintain and grow your wealth would have been to go on investing in gold. Gold prices seems unstoppable. They've reached levels that would have been unimaginable a few years ago and gold cheerleaders say that they are on their way to levels that are unimaginable today.

When investors go and look for information on whether gold is still a good bet, there is no shortage of strong and apparently well-reasoned arguments supporting why gold prices will continue to rise. There are many variations to these arguments, but basically, they all boil down to some version of the 'safe haven' theory, viz. that investors are fearful of the future of stocks, bonds, currencies and all other kinds of financial investment. They think that there could be another financial crisis and are thus being smart in rushing in to an asset type that has a historical reputation of protecting wealth in bad times.

Not just the financial media, but even the general media now carries articles recommending gold as a significant chunk of individual investment portfolios. As a mainstream financial investment, Gold's day appears to have arrived. Or has it? Will gold live up to the hype? Definitely, the hype has now reached impressive levels. On the Internet, it's not difficult to find apparently sane analysts who say that gold could rise to four times today's price in five years. Projections of two to three times today's price levels in a year or two are commonplace.

Is this a bubble? The truth is that in any sensible discussion, that question is not even worth asking. Of course gold is a bubble--what else could it possibly be? The gold of today is not the gold of old--a largely physical asset that was a safe haven in troubled times. This is a paper asset; with highly liquid and highly leveraged markets where derived proxies of gold trade in much larger quantities than any underlying demand. This bubble is like the other commodity bubbles that you have seen over the last few years, whether oil, copper, nickel, wheat and so many others. In fact, gold is even more of a bubble because it is an inherently useless material, earning no dividends or interest. There's no industrial consumption story like copper or nickel here, and unlike oil, there isn't any danger of 'peak gold' laying waste to the world economy. Gold is the purest of all bubbles-where even the story being told by its proponents is that they expect its price to rise because everyone expects it to rise.

Sure, if you think this bubble will continue then by all means try and milk it for all it is worth. Bubbles are by definition irrational and who knows, gold's price could actually rise five times in five years. But if you invest in it today, have no illusions that you are putting away money for a rainy day. You are actually speculating that a particular madness will continue for a while. One day this madness will end suddenly, and then you'll have to run away. When that day comes, how much money you finally make will depend on whether you can outrun the stampede for the exit gate.

This article was originally published on July 09, 2010.