Are You Entranced by the Glitter of Gold?

In the past couple of years, mostinvestors have wondered if theyshould place part of their portfoliosin gold. The gold bugs arecertainly back, and the price ofgold has come alive again after a longdormant period.

Gold Bug Bites

The case that most gold bugs makeis that the price of gold is on the wayto $850, $1000, or higher, and this isthe time to get in for a good ride andthen get out when one of those targetsare reached. I advise against taking thisapproach because this is pure speculation.In the short run, the price of goldis mostly determined by market sentiments,which even the most ardentgold bug cannot predict. It is possibleto make a somewhat stronger case forbuying gold as a longer-term hedgeagainst inflation or possible economicdisaster. With the growing trade andbudget deficits, looming Social Securityand Medicare crises, terrorismthreats, tight oil markets, etc, it is notdifficult to conjure up some scary economicscenarios.

If you buy gold to protect yourselfagainst economic disasters, you will becounting on gold as an inflation hedge.If you had invested $1000 in gold backin 1801, 200 years later in 2001 (afteradjusting for inflation), it would havebeen worth $980—an annual realreturn of essentially 0%. In otherwords, over the 200-year period goldjust about kept up with inflation anddid no better. The same investment instocks would have grown to about$600 million (adjusted for inflation),which is an annual real return of6.9%. Investment in bonds wouldhave grown to about $1 million, for areal annual return of 3.5%. Incidentally,inflation averaged 1.4% peryear over this period.

Inflation Protection

Clearly, over 200 years stocks andbonds were much better inflationhedges. However, within this longstretch there were some periods whengold did better than stocks and bonds.The most compelling case for gold canbe made by looking at the yearsbetween 1966 and 1981. This was theperiod of highest inflation (ie, 7% peryear) in recent times, and gold did actas a very good hedge against inflationby providing an inflation-adjustedreturn of 8.8% per year. Over this timereturn in stocks after adjusting forinflation was a loss of 0.4% per yearand in bonds a loss of 4.2% per year.

So if things get really bad and inflationskyrockets again, it is possible thatgold would be a great inflation hedgealso. But keep in mind that you have tobe prepared to accept losses untilthings get really bad, because in recenttimes when inflation was in the normalrange of 2% to 3% per year, gold lostvalue in inflation-adjusted terms.Another point to remember is thatwhile you hold gold, you will incur anopportunity cost of about 6% per year.By tying up your money in gold, youwill forego a safe return of close to 5%per year that you could have earned ina money market fund.

The best way to invest in gold isprobably through the streetTRACKSGold Shares (GLD). You can considerbuying some gold stocks or a fund ofprecious metal stocks, but that willalso expose you to the risks and benefitsof owning stocks. GLD is a pureplay in gold.

Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (John Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at chandansen@aol.com.