Should You Buy Gold?

Gold has a tendency to be a popular alternative investment, but is it a smart choice for long-term investors?

Gold has a tendency to be a popular alternative investment, but is it a smart choice for a long-term retirement planning investor? For starters, it's important to note investors' love of gold is more than a calculated financial decision, it's also an emotional attachment. This potentially goes back to Spanish galleons and sunken treasure, or maybe to the fact the worlds' currencies weren't fully divorced from the gold standard until late 1973. Either way, the history of currency and exchange is heavily intertwined with gold. This can make it difficult to separate fact from myth.

Part of the emotional appeal of gold is the idea it's an inflation hedge. Anything that seems to be able to protect purchasing power is bound to sound appealing. However, gold doesn't deliver on this count. A common fallacy is gold rises in periods of high inflation, serving as a stable store of value. This sounds attractive, but for it to be true, gold would have to move in lockstep (or close to it) with the Consumer Price Index (CPI, the broadest measure of inflation). As you can see below, this isn't the case.

Exhibit 1: Gold and CPI Aren't Relatedi


CPI has risen steadily over time at a rate of about 3%ii, while gold endured long periods of stagnation or decline. The lines above indicate little correlation.

Over time, stocks' tendency to rise and outpace inflation make them a more practical choice for investors worried about losing their purchasing power. But people invest for more than inflation protection, what about gold's price and ability to be a factor in growing your portfolio?

When you think about gold's price, remember it's a commodity and prices are driven by supply and demand. Supply doesn't change much in the short term because mining can only add a modest amount of new gold every year. That means price movements are mostly driven by demand. Gold is of limited industrial use, so investment demand is the main driver of price movements (jewelry demand can also be a factor).

Gold had a nice run from 2005-2011, likely a reason for its current popularity, but has declined sharply since. This isn't unusual with commodities. They're prone to boom and bust, followed by long periods of stagnation. Stocks on the other hand tend to rise much more often than fall on an annualized basis.iii

This debunks another common reason investors turn to gold—the disaster scenario. A myth on par with inflation protection is gold does well in a bear market, when stocks are crashing. Gold didn't return to its early 1983 high until 2005, a period spanning three stock bear markets (1987, 1990-1991, 2000-2002). Investors who turned to gold for protection were likely disappointed and didn't get the benefit of stocks' ride back up.

Making money in gold is a question of an investor's ability to successfully time what can be sharp, short-term swings driven mostly by sentiment. Long-term returns have historically disappointed since gold started trading freely in 1973, vastly underperforming the stock market, as can be seen below.

Exhibit 2: Stocks Outperform Gold Over Timeiiii

Thus, while gold may hold an emotional appeal, successful long-term investors would be better served to view it as what it is—a commodity offering limited inflation protection and a propensity to sharp sentiment swings.

i Source: FactSet as of 5/21/2014. CPI and Gold, London Close 11/30/1973-4/30/2014.

ii Source: Global Financial Data, Inc.; as of 1/18/2013. Based on US BLS Consumer Price Index from 1925-2012.

iii Source: FactSet as of 5/21/2014.

iiii Source: FactSet as of 5/21/2014. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of 23 developed market country indices. Returns are presented inclusive of dividends, the effects of withholding taxes, and use a Luxembourg tax basis.

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