Wednesday, October 7, 2009

Buy Gold?

These days we are bombarded with TV and radio ads urging us to buy gold. Why don’t we own gold in the portfolio? This is a common question during a recession, as gold is a store of value that gains popularity during times of fear and crisis. Since gold is volatile, speculative and offers little expected return – we feel it does not belong in your portfolio.

Portfolio design considers three primary measurements: return, volatility and correlation. The initial step is to diversify away the un-rewarded risk of individual stock, bond or REIT (Real Estate Investment Trust) selection. We do this by owning thousands of Stocks, Bonds and REITs through mutual funds. The next step is analyzing the return, volatility, and correlation of prospective asset classes. The primary asset classes in your portfolio (Stocks, Bonds and REITs) are justifiable ingredients. They offer expected return. They produce something to validate the expected return. The expected return is proportional to the risk and they offer correlation benefits (they do not move in tandem - when one is down, the other may go up).

Gold, however, does not meet these criteria. Gold does not produce anything. It has not delivered real returns (to the extent gold is a hedge against inflation, returns should keep pace - however it hasn’t really proven reliable as an inflation hedge). More importantly, gold prices are volatile and unpredictable. Gold carries volatility similar to stocks, without the payoff. Gold prices peeked in 1980 at $612 per ounce. For 26 years (until the end of 2006) Gold prices were well below the 1980 peak – that is a twenty-six year period with zero (or negative) return. Although it can offer negative correlation benefits, especially during times of crisis (a crisis hedge), the volatility is not rewarded with consistent return.
Buying gold is a speculative move. You buy hoping your “timing” is right. Now and then you “strike it rich” when the timing is perfect. Over the long haul, however, gold’s investment return has been dismal – not bright.

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