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Fool’s Gold



There are few investing myths as persistent as Gold.  We like the idea of something we can touch, hold in our hands.  We want to believe that there’s an antidote to market volatility.  We like shiny things.

Gold is pure speculation.  It is gambling, pure and simple.  And if it is understood as such, go have a blast.  Try to buy at the bottom; sell or short it at the top.  Get in, get out, and good luck.

But often we hear another rationale for owning gold, one that belies a lack of understanding of basic math.  The thinking goes something like this:  We don’t know when the market will go up or down, so we invest for the long-term.  However, gold generally goes up when the stock market is going down, so we’ll hold some to “hedge” the portfolio.

This, my friends, is a contradiction.  A cognitive dissonance.  A statistical fallacy. EITHER you are investing for the long-term OR you are trying to time the market and outperform.  The latter has been proven statistically nearly impossible to do through skill, but the game is too exciting for some not to try.

Start with the assumption that the stock market will go up over a long period of time.  Therefore, you invest for the long-term and diversify.  The reason to diversify is that while everything will go up over long periods of time, not all segments of the market move in the same direction at the same time.  Diversifying helps level the path on the way up.

So why not add gold? Because gold does not increase in value over time.  It is not a return-producing asset.  Gold is a piece of metal.  It does not create or add value.  In fact, over long periods of time, it just keeps up with inflation.  Stocks, meanwhile, represent a share in a company that produces goods and/or services.  As the company grows, the stockholders share in that growth.

From the book Basic Economics by Thomas Sowell, “… a dollar invested in bonds in 1801 would be worth nearly a thousand dollars by 1998, a dollar invested in stocks that same year would be worth more than half a million dollars in real terms. Meanwhile, a dollar invested in gold in 1801 would by 1998 be worth just 78 cents.”

If you’re creating a diversified portfolio for long-term investing, there is no place for an asset with zero real return.  It is not possible to create an efficient portfolio – one that maximizes expected return for its level of risk – when incorporating an asset with an expected return of zero.  It seems silly to even have to say it, but all long-term investments should have positive real expected returns.

Yes, gold often rises in price when the stock market is falling, but attempting to time the bottom and the top is fundamentally at odds with the principles of long-term investing.

What do we call an asset with high volatility and no real return?  An investment?  No.

Gold?  Yes.

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