Myths Debunked...  

The first step in having a realistic discussion of Gold and its investment attributes is to debunk the myths commonly held regarding the yellow metal.  Let's begin with the biggest one...Gold is a hedge against inflation.  Inflation, defined as a general rise in prices, has no historical correlation to the price of Gold.  Not only is there no correlation, but the data shows that during certain inflationary periods Gold actually lost value.  A related myth about Gold is that it is a good hedge against the decline of the U.S. dollar.  Again, historical data shows a rather small, negative correlation (negative correlation means one goes up as the other goes down) between the U.S. dollar and the price of Gold.  That correlation has gotten stronger since 2003, which might be explained by 1) the U.S. dollar being particularly weak since 2003, and/or 2) the introduction of Gold ETF (Exchange Traded Fund) vehicles increasing Gold investment volume.  Both of these have undoubtedly contributed to the Gold vs. U.S. Dollar negative correlation, but even this higher correlation since 2003 is not at an overwhelmingly convincing level.

Another popular myth is that Gold is a safe-haven asset immune from losses.  Again, historical data shows that myth to be inaccurate.  Looking at data since 1975 (after the U.S. dollar went completely off the Gold standard) Gold lost money on numerous occasions.  In fact, from early 1980 to early 2002 the price of Gold tracked predominantly downward.

More often than not, individual investors buy Gold based on emotion.  That emotion, as I said earlier, is usually fear of inflation or dollar meltdown or global financial calamity.  The other common emotion is greed, where investors pile into Gold when they see the price has increased dramatically and they want to participate in the gains.

As you might surmise from the above, I am not a big fan of Gold as an investment.  The primary reason for my resistance is valuation.  In other words, what is an ounce of Gold worth?  Without a valuation method how do you know at what price to buy or sell?

There is one possible methodology that could help us determine if Gold prices are in a positive trend.  It is based on the idea of real interest rates.  Real interest rates are simply current nominal interest rates (what you earn on savings) adjusted by the current rate of inflation.  Today we have low or negative real interest rates because the current rate of inflation is high compared to the current nominal interest rate.  When real rates of interest are low, as they are today, Gold tends to gain in value.  High inflation combined with high nominal interest rates is relatively neutral to Gold prices, while high nominal interest rates, combined with low inflation (i.e. high real interest rates) can drive down the price of Gold.  Given this possible relationship, Gold would appear to be in a positive trend since real interest rates are not yet moving up.  But this method has a high degree of volatility and requires a forecast of real interest rates...not an easy task.

However, Gold isn't a complete strike out.  As part of a more broad-based commodity investment strategy, I think the yellow metal has a place.  For those willing to endure the risks, a small allocation to a commodity oriented investment might be a good idea as a portfolio investment.  Commodities do not pay interest or dividends, so their returns come solely from capital appreciation.  But given their lower correlation to stocks and bonds, such an investment might make sense for all but the most conservative investors.