Over the past nearly ten years, I’ve heard, probably at a minimum, a few dozen versions of the following theory: In a world of large deficits and high inflation, Gold is the only asset that can save investors from greedy central bankers, spendthrift sovereign governments, and the unrelenting effects of inflation.
Have you heard of the Lindy Effect? No shame if you have not! … The Lindy Effect is the theorized phenomenon that the life span of a non-perishable item is proportional to its current age. Essentially, the longer something has been around, the longer it’s expected to last.
The Lindy effect and Gold are joined at the hip…and for a good reason! The history of gold dates back nearly to the beginning of human records. The oldest gold artifacts date back to the 5th millennium BC (4600-4200 BC) in present-day Bulgaria. This roughly dates the use of Gold back 6,000 years! Extending the use of Gold as a currency started around 50 BC with the Roman aureus, a gold coin. Additionally, for much of its history from the late 1790s through 1971, the United States used Gold in various ways to peg its currency.
So, with all that history, why are investors likely ill-suited to put everything in the shiny metal?
Truth Serum
In order to unpack the best role for Gold in a portfolio, we must examine the foundations of why things go up in value over time and the difference between short and long-term investing:
Starting with the former, the most foundational concept in capitalism is the idea of innovation. If not for the monumental efficiency, technology, and manufacturing benefits, mankind would’ve never left the Feudal period. At its core, the measure of progress is the output generated per man-hour. What started with a plow evolved into a steam engine, and today may take the form of Chat GPT, is really all the same concept—doing more (output) with less (input). Over the centuries, this growth has created modern society, and in the last 200 years or so, the stock market has provided those with capital the ability to benefit themselves from this progress.
History also tells us that the value created for investors and business owners from this progress has been far above that generated by any other asset.
Dating back from 1825 through 2019, the US Stock market returned an annual return of 9.56%. (Visual Capitalist)
When over 100 years of data for both stocks and Gold are compared, the difference is magnified. From 1915 to March 2023, Gold has increased in price relative to US Dollars by 10,100%. However, the Dow Jones Industrial Average has increased over 58,000%. Meaning the increase of stocks over 100 years was more than five times that of Gold. (Macro Trends)
No Cash (flow) for you!
Another area where gold struggles to match the returns provided by other asset classes is in cash flow. While the advent of exchange-traded funds (EFTs) that can track the price of assets like Gold makes investing in it cheaper and easier than it once was. Unlike stocks, bonds and real estate, Gold does not provide dividends, putting it at a disadvantage in terms of long-term returns.
Taking this a step further, you might still be thinking about the 10,000+% increase in the price of Gold I referenced above. That sounds (and is) a lot. Over time the purchasing power of a dollar goes down and has for 200 years. HOWEVER, that doesn’t make dollars bad. The missing link in the data above is the missing component of interest. While $100 buried in the backyard would still be $100 if it were dug up 100 years later, most investors attempt to earn interest on their cash if they don’t plan to spend it immediately. Specifically, $100 rolled in 3-month Treasury Bills (similar to 3-month Bank CDs) since 1928 would have grown to $2,140; a 21-fold increase just from the interest earned on cash.
How many ounces for that car?
Gold also faces a common problem with its upstart cousin, cryptocurrencies: nothing is priced in Gold. This means that to actually buy something, one must translate Gold into dollars before purchasing, placing them at risk if the price of gold drops for a period of time. For instance, the price of Gold peaked in 2012 and did not regain its previous high until 2022, resulting in eight years of declining purchasing power. Although investing in stocks entails some level of risk, dividend-paying equities provide regular cash flow, while interest-paying investments like bonds may be more suitable for short-term needs. (NYU Stern School of Business)
The role for Gold!
While this might seem like an outright negative take on Gold, that’s actually not my opinion. Gold has a use as a part, albeit normally a small part, of a diversified portfolio. Gold performs best when inflation is high AND interest rates are low, these conditions are not usually experienced together, but because Gold performs well in this environment, an allocation to it may make sense when ADDED to a portfolio of stocks and bonds.
If the US Economy were to go the way of the Weimar Republic, then Gold would likely perform among the best assets, but as Warren Buffett said in the Financial Crisis “The world only ends once… so you’re better off betting against it.” Historically the best way to capture the value of innovation is through owning a business or owning a collection of businesses via the stock market, and as a result, I believe investors should strongly take this into account when constructing their portfolios.
July 2023
