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Why gold isn't dead

Since gold acts like a hedge against inflation, investing 5 to 10 per cent of portfolio assets in gold isn't a bad idea

Why gold isn't dead

Unlike the editor of this magazine, I have been a big votary of investing in gold over the years. This advice is subject to the corollary that you shouldn't bet your life on it and at best have 5 to 10 per cent of your portfolio in gold. Investing in gold is essentially an insurance against all hell breaking lose in the global financial system.

Central banks have printed money at a very rapid rate since the start of the financial crisis in September 2008 and continue to do so. And as much money as has been printed can only lead to inflation - someday. At least that's the logic I have had to offer every time I have written a column on gold, up until now.

I need to admit here that between 2008 and 2011, this advice was influenced by numerous gold bugs I interviewed as a personal-finance journalist. Each one of them gave me a huge forecast on gold. One of them even said that at its peak gold would touch $55,000 per ounce (one ounce equals 31.1 grams). Nothing of that sort has happened. So what was the trick here? None of them gave the time frame by when the price of gold would shoot through the roof. Hence, for all we know, they might still prove to be right.

As I write this in mid-September 2015, the price of gold is a little over $1,100 per ounce, having crossed $1,900 per ounce four years earlier, in September 2011. The global economy has gone from one economic crisis to another. There have been economic problems in Europe. And now China seems to be joining the bandwagon as well. Nevertheless, the price of gold instead of going up has been coming down. The era of high inflation is nowhere to be seen and much of the developed world is essentially facing low inflation or even deflation (a period when prices are falling) in some cases.

Those who are against investing in gold essentially like to point out that gold is not an investment. There is no interest that one can earn out of it. Neither can one earn any dividend out of it.

Also, despite having a reputation of being a solid store of value, that has not always been the case. As John Plenary writes in Capitalism: Money, Morals and Markets: "In real terms, the price of gold in 2012 was similar to the prevailing price in 1265." So doesn't it mean that gold has acted as a store of value over the last 1,000 years? Not really. As Plenary writes: "Over much of that time, though, the yellow metal failed to live up to its reputation as a solid store of value."

Why does Plenary say that? This is explained by strategist Dylan Grice, who used to work for Societe Generale. As Grice writes: "A fifteenth-century gold bug who'd stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years."

In fact, even those who had bought gold at the peak of the 1971-1981 bull market in gold would have lost around 80 per cent of their investment in real terms, over the next two decades.

So gold has not acted as a store of value over the last 500 years, though it has acted as a store of value over 1,000 years. Hence, whether gold has acted as a store of value or not depends on the time frame one looks at.

Further, those who are against gold have pointed out that over the long term, stocks have been a better bet. The trouble with most such calculations is that they look at index returns without looking at the specific stocks that make up the index at a given point of time.

Nick Barisheff makes the point well in $10,000 Gold: Why Gold's Inevitable Rise Is the Investor's Safe Heaven: "One cannot compare gold held in a vault to an investment in stocks. Stocks cannot be compared to gold when it comes to risk. Virtually all of the stocks that existed in 1700 no longer exist today, so at some point investors and their descendants would have lost their entire investment." And that is a fair point.

If we look at the BSE Sensex as it was nearly two decades ago, it tells us a similar story. Back then the Sensex did not have many of the big financial and IT companies that it currently has. Further, many companies which constituted the Sensex at that point of time, the likes of Futura Polyster, Premier, Hindustan Motors, GE Shipping, CEAT, India Hotels and Bharat Forge, are no longer a part of it.

Hence, equities-for-the-long-term story, like gold- for-a-safe-haven story, also doesn't work in all cases. Where does all this lead us to? Let's see what John Plenary writes: "The economist Willem Buiter points out that [gold] has had a positive value for [nearly] 6,000 years, making it the longest-lasting bubble in human history. Maybe, it will be good for another 6,000 years."

Also, with all the money that has been printed and continues to be printed, inflation still remains a possibility. As James Rickards writes in The Big Drop: How to Grow Your Wealth During the Coming Collapse: "You can print all the money you want and we haven't had inflation. But that's only because the behaviour hasn't changed. Again, once the behaviour does change... the inflation can come very quickly, much more quickly than people expect."

And this is a possibility that one needs to be prepared for. As Plenary writes: "I do not think it is completely irrational to hold it [i.e. gold]. Forgoing income on this precious metal is the equivalent of paying an insurance premium against future inflation. The snag is that because gold is purely speculative... the price is inevitably volatile and tends to overshoot both upwards and downwards, sometimes over long periods."

Also, the chances of Western central banks maintaining low interest rates as well as printing money continue to remain high. As Christine Lagarde, Managing Director of the International Monetary Fund (IMF), said recently: "The major challenge facing the global economy is that growth remains moderate and uneven. For the advanced economies, activity is projected to pick up only modestly this year and next... A concerted policy effort is needed to address these challenges, including continued accommodative monetary policy in advanced economies." The term to mark here is accommodative monetary policy, which is nothing but a euphemism for an era of easy money unleashed by central banks.

And keeping this factor in mind, as Plenary writes: "The lesson of the past 6,000 years is that, however uncertain the payout on the insurance policy, it will be a better than holding government IOUs in a period of monetary dislocation and high inflation."

And that is something worth thinking about even for those who don't believe in gold.

Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected]

This column appeared in the October 2015 Issue of Wealth Insight.