Boom2Bust.com

Gold: Not So Precious? Part 2

Yesterday, I brought up two Wall Street Journal articles that talked about gold as an investment. In the post, I discussed some of the precious metal’s alleged shortcomings, as pointed out by Jonathan Burton and Eleanor Laise. Today, I’ll take a closer look at some of these “drawbacks.”

In his August 15 Journal piece, Jonathan Burton wrote the following about gold and its place in a diversified investment portfolio:

…as an investment, short-term risk is high and long-term reward is marginal.

Regarding Burton’s claim that gold’s short-term risk is “high,” there’s no doubt that the yellow metal’s price volatility is legendary. Yet, if I’m a long-term investor, as opposed to a short-term trader, am I really concerned about short-term price gyrations? I would think the same applies for someone looking to diversify their investment portfolio. Wise investors see price dips as potential opportunities for accumulating more of an asset at depressed values.

Going back to the issue of diversification, I know Burton wrote that gold is not really “needed” in that capacity. However, I’ve seen studies that claim the precious metal may help increase returns and reduce portfolio risk. In the March/April 2006 issue of the Financial Analysts Journal, David Hillier, Paul Draper, and Robert Faff wrote in “Do Precious Metals Shine: An Investment Perspective” that gold can improve portfolio performance. According to their research:

Through analyzing daily data for the 1976-2004 period, we showed the following: Gold, platinum, and silver have the potential to play a diversifying role in broad-based investment portfolios… Financial portfolios containing a moderate weighting of gold perform better than portfolios consisting only of financial assets.

Chicago-based Ibbotson Associates also produced a study in 2005, entitled “Portfolio Diversification with Gold, Silver and Platinum.” They concluded that:

Investors can potentially improve the reward-to-risk ratio in conservative, moderate, and aggressive [risk orientations] asset allocations by including precious metals with allocations of 7.1%, 12.5%, and 15.7%, respectively. These results suggest that including precious metals in an asset allocation could increase expected returns and reduce portfolio risk.

Finally, Burton wrote that gold’s long-term reward is “marginal.” This would appear to be the case when comparing the metal’s performance to stocks, for example, which have achieved average annual returns of 7% (after adjusting for inflation) since the early 19th century. After hitting $847 an ounce in January 1980, gold futures fell for almost 20 years, grinding down to $253 in August 1999, a 70% drop. Gold remained dull until 2001. However, prices have more than tripled since then. Couldn’t it be argued that whether or not a reward is “marginal” depends upon the entry/departure point in a particular market? Case in point, U.S. stocks have been part of a larger bull market since 1982. However, those who were on the Street prior to that time might recall that stocks went practically nowhere from 1966 to 1982. Had I invested in the stock market during that era, I might have concluded that my long-term reward was “marginal.” Consider this. If an investor had $1,000 in the stock market on September 3, 1929, the value of their investment would have plummeted to $108.14 by July 8, 1932, or an 89.2% loss. I know… we’re supposed to be talking about the long-term here. Well, if the stock investor had waited around for their portfolio to break even, it would have taken until 1954, 22 years later. I have a feeling they would also have concluded that their long-term reward was “marginal,” unless, of course, they were in a complete state of denial.

Well, that’s it for today. On Sunday, we’ll take a closer look at some other “drawbacks” of the yellow metal in the final part of this series.

(Note: The author disclaims any personal liability, loss, or risk incurred as a consequence of the use and application, either directly or indirectly, of any information presented herein.)