“Is Gold a Safe Investment?”

People get excited about gold when it’s exciting. Right now, gold happens to be on one of its wildest rides in recent history. It only makes sense that interest in gold is stirring. Here’s a brief run down of why gold has been hyped up recently:

• The global impact of Coronavirus on developed and developing economies.
• Industrial need for gold had been climbing through the period of economic growth right up until a few weeks ago- industrial use accounts for about 17.5% of all global gold demand. 1
• Rising affluence (again, until very recently) of the Chinese Middle and Upper Class- China represents somewhere between 28 and 35% of the global demand for gold in a given year and has the world’s largest gold exchange in Shanghai. 2
• Fears that the U.S. Fiscal & Monetary stimulus policies are more or less massive money printing that will result in rising inflation.

It’s a perfect storm in the gold market right now. Physical demand is through the roof. Just read this salacious Bloomberg article from this weekend detailing the physical gold market hijinks of high flying traders for a taste of the recent chaos in the gold market. Anecdotally, I noticed this chaotic state of the market myself when I went to take a routine glance at my favorite online precious metals broker last week: they had no inventory. That’s not an exaggeration. They did not have a single gold bar, coin, or round in stock. For the first time in 12 years of regularly patronizing this globally dominant broker, they had nothing to sell me.

I say all of this to get the “noise” of current news about gold out of the way early. All of these facts should be starting to point in concert to one simple truth about gold in the 21st century: if a “safe” investment means one with high liquidity and low volatility, gold is definitely not those things. Looking beyond the current news about gold to the constants in precious metals investing is key to developing a true understand of this asset class.

Gold does not produce any cash flows. This may seem obvious, but it’s one of the most important distinguishers between gold and other types of investment. The price of an asset is the sum of all future cash flows discounted back to the present dollar. In less technical terms, we know the price of something in the market by the income it is expected to produce.

This axiom of asset pricing is more than just the secret sauce of Wall St.’s vast price analysis machine. It tells us that gold is not at all similar to stocks, bonds, or even cash. When we can know information about cash flows from an investment, we have a stable, fundamental basis for knowing a fair price of that asset. We can’t do that with gold.

That leaves gold to the devices of commodity market speculation. Since there is no intrinsic value of gold, the price is constantly being arrived at every minute of the trading day. There are a few factors to the price of gold that tend to inform the market:

• Industrial demand for gold, for example its use in Semiconductors.
• Jewelry demand.
• Investor sentiment.
• Inflation of the US dollar and related global trade currencies.
• Quantity of new gold production from gold miners.

What this leads to is a highly volatile market with one or another factor driving price trends at any given time. Technically, gold is a commodity and some might expect gold to behave like other commodities. Commodities are typically either consumed or used in the production of finished goods that are themselves consumed. Commodities and consumption go hand in hand.

Nonetheless, a small minority of the gold market is driven by classic commodity supply/demand economics, as you’ll see in the chart below. Instead, gold is largely used in apparel and for investing and/or market speculation. People buy it in the markets because other people will probably want it later, which defies much of what we know about commodity markets and creates a constant, fundamental uncertainty in the price of gold that is reflected in its highly erratic performance as an asset.

As a final note, jewelry consumption cannot be separated from investing and speculating with any certainty. In some of the world’s most important gold markets, gold jewelry is purchased as a status symbol and store of value simultaneously. This is the case in China, India, and Indonesia- a few of the world’s largest gold markets. There are cultural, historical, political, and economic factors behind these trends that defy attempts to make a hard distinction between investing and ornament in gold consumption.

The most widely used measure of risk is Standard Deviation. This describes what is statistically likely in a given year for an asset, and it can be used to compare asset classes to each other. Standard Deviation is the percentage an asset is likely to gain or lose in the average year- you could expect to be up or down this number year over year. Gold’s recent standard deviation in 18, so investors should expect a 36% range of outcomes in an average year. This is much riskier than other asset classes, as you’ll see in the Standard Deviation chart below.

Gold’s Standard Deviation is far above that of the Stock Market in recent years. It’s also far more volatile than the universe of commodities as measured by commodity ETF’s (I like to reference the United States Commodity Index ETF, Ticker: USCI). Of course this means it’s also dramatically above bonds.

One key statistic that derives from Standard Deviation that tells investors how much return they’re getting per unit of risk is the Sharpe ratio. Basically, it helps us compare risk-adjusted returns across asset classes. It’s not enough to know we may get potentially higher returns from an asset- we want to know how much reward per how much risk we’re getting, and Sharpe ratio is a simple and useful measure of this.

The higher the number the Sharpe ratio is, the better, with a “good” investment historically being well above 0.75 and the ideal being at least 1 or near 1. Gold’s Sharpe ratio over the past decade has been 0.25 versus the Stock Market’s 0.95. Quality bonds have averaged well over 1 for over a decade.

What this all tells us is that over the past decade, the Stock Market has been less risky; has returned more per measure of risk; and returned more in Total Return (yes, even after the recent pullback) compared to gold. Using this lens of whether or not gold is a “safe” investment, gold is actually one of the least safe investments using empirical analysis.

So far we’ve look at gold through lenses that cast it as an extraordinarily risky and unpredictable investment compared to other investments. You’re probably wondering how the notion that it is “safe” came to be in the first place. I will give the shortest round-up of this idea possible, not to give these ideas a platform so much as to place what we know about gold as an investment next to the argument that it is a uniquely safe investment. In less diplomatic terms, I don’t give the claims of gold’s “safeness” any credence as an analyst.

Until very recently, gold was money. The Gold Standard, where the U.S. Dollar was pegged to the the value of gold, only ended in 1973. Before that, our money itself was precious metal (often silver). The U.S. was just closing in on 100 years old before we printed the first dollar.

Some variation of gold or silver being money itself was the norm for most (some would argue all) of the history of Western Civilization. Its use as money or a store of value exchangeable for money has been documented all over the world for at least 5,000 years. For Generation X and the Millennials, the Gold Standard is a mere historical fact, but millions of Americans today recall the Gold Standard as the basis of our currency and a vocal minority of economists and politicians hold it up as a bygone ideal.

For people who are nostalgic for the days that the dollar was hypothetically redeemable for gold, the commodity itself is still what money should be. Alan Greenspan, the Chair of the Federal Reserve from 1987 to 2006, said only a few years ago of gold: “Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it.” 3. Advocates for the gold standard occasionally are quite influential.

It’s on this foundation of speculation that the U.S. Dollar is fundamentally unsound and that our current monetary system will someday- perhaps someday soon- collapse that the argument that gold is a “safe” investment rests. The argument is that gold will somehow prove itself to be the real money in the end. The lines between politics, ideology, economics, and personal finance are blurred by some who exploit this fear-based reasoning. I’m not a politician or political analyst, so my 2 cents on the ideological facets of this argument are largely irrelevant.

What I can say about this argument is that theories about the dollar’s instability are highly speculative and outside the norm. There are reputable Credit Rating agencies that understand and report the real risk of currencies better than I or any other individual can: Moody’s, Fitch, Standard & Poor’s, etc. Since our currency system certainly has a large debt component, our Credit Rating as a nation is highly relevant to how likely a “Dollar Collapse” really is. To put it bluntly, it’s simply more prudent to listen to Credit Rating agencies about America’s monetary policy risk than ideological soothsayers. In that context, these agencies rate us the highest Sovereign Credit Risk rating attainable, which is a far cry from a nation with a currency on the verge of collapse.

The lowest risk way to invest in an asset, generally speaking, is to choose the most liquid option with the lowest transaction costs. When I say liquidity, I mean the ability to sell what you have expediently for a price closest to what you should expect. This may sound obvious, but in the world of gold investing, it can be very confusing for beginners, and I’ll give an example of why just buying some gold coins from a broker or coin shop is not as liquid as you’d think.

The Krugerrand is one of the most popular gold coins in existence. It’s minted in South Africa and one of the most reputable, liquid, and durable gold coins you could own. If you bought 10 of these from Monex (one of the major brokers) today, you’d pay $17,089. If you sold 10 Krugerrands today to Monex, they’d pay you $16,470. That difference is called “the spread,” and it’s how brokers make their money, which surely they have to do to be in the business of brokering. Nonetheless, you will always pay more than the spot price of gold and be paid less than the spot price, which limits the liquidity of the investment.

You’re guaranteed to lose a number of percentage points from the spot price (in this case, 3.57%, which is relatively low). Your cost of transaction will always be between 2.5% and 5% or more. In a world where ETF’s can be purchased for free or under $5 per allocation, this is an enormous relative cost. If you paid 5% on both sides of the transaction (which is likely), that’s a 10% cumulative loss to transaction costs. These costs need to be imputed to performance evaluation, but many investors forget to do this.

There is a way to invest in gold that has low transaction costs: investing in gold through ETF’s. As an investor in this asset class myself, I tend to see this as the safest and easiest way to invest in gold.

To give you an example of a gold ETF worth considering for safety of investment, the VanEck Merck Gold Trust (Ticker: OUNZ) invests in physical gold with your money that’s stored in a vault by Merck. The expense ratio is relatively low, especially compared to the proportional cost of safe/vault storage you’d pay on your own. It’s always a fraction of the price of gold (currently a little over $15/share), making it possible for investors to build a stake little by little. The unique thing about this ETF is that you can exchange your shares for physical gold bars or coins if you choose to go the physical ownership route eventually once you’ve built up a large enough position. In full disclosure, I own this/will own this as well as the SPDR® Gold ETF (GLD) and the iShares Gold Trust (IAU). This is not advice for you to go buy OUNZ or one of the others, but to start you on a research track (I strongly advise that you always consult a qualified, fiduciary advisor who will advise you on your best interest before buying any investment!).

Lastly, I’ll give you my personal opinion on who fits the profile of an investor that could consider investing in gold. Ideally, this investor:

1. Has a considerably large net worth to income ratio
2. Has a portfolio that is large enough to have adequate stakes in Asset Classes with better risk adjusted returns (i.e. a $3,000,000 portfolio that already has large positions in various Equity & Fixed Income investments)
3. Needs new ways to diversify a very large portfolio
4. Has reason to be concerned about inflation and already has sizable investments in other inflation hedges (Real Estate, Inflation linked bonds, etc.)
5. Is in the most aggressive risk tolerance category
6. Has extensive investment experience and expertise, enough to fully understand the risk/reward trade offs of gold in context
7. Has elevated international currency risk for some reason (i.e. personal business interests on multiple continents)
8. Travels to countries with near-worthless currencies experiencing hyperinflation (e.g. Zaire in the 1990’s, Zimbabwe, Venezuela, etc.). No, I’m not kidding about this example- this is a very real argument for physical ownership of gold and silver
9. Understands Sovereign Credit Risk of fiat currencies comprehensively
10. Can tolerate extreme loss scenarios of more than 40% in a year
11. Understands both Technical and Fundamental analysis tools of investing
12. Has an investment approach that is tied to cycles (and specifically the Credit Cycle)

There are certainly investors who check enough of these boxes to warrant a gold allocation, and I personally enjoy advising such individuals. I don’t want to give the sense that no one should own gold. I think that the people who could own gold reasonably should give it a look.

Finally, I want to note that no one should have more than 5-10% of their money in gold (or silver, or any other commodity). Sadly, when I hear people talk about investing in gold, it is often in the context of selling 100% of their Equities and going all in on gold. There is no one who should do this. It’s not even remotely a prudent strategy, and it will likely end in grave heartache for those who attempt it. Another one I’ve encountered that I find very upsetting is the “Precious Metals IRA,” where people put 100% of their retirement savings in one of the least secure asset classes which produces not a dime of income or cash flow. This is one of the few strategies that I am vehemently opposed to in all circumstances.

For anyone considering the gold IRA route that is dead set on having some gold in their retirement strategy, there are much better alternatives. Please contact myself or a qualified CFP®, AIF®, or other Fiduciary advisor in your area.