3 Reasons to Avoid Gold

gold pendulumGold is often touted as a must-have investment for the most intense of risk-mitigation situations, a “when all else fails” hedging instrument. Indeed, pick an ailment: Inflation? Hedge with gold. Economic and political crises? Hedge with gold. Collapse of modern society? Say it with me, folks, “Hedge with gold”. With the global economy as shaky as it is, multiple countries in one crisis or another, and plenty of uncertainty as to what the future holds to go around, gold continues to make the rounds as a necessary holding despite the fact that its value in US dollar terms has been steadily declining over the last four years after reaching a peak in 2011 of almost $1,900 an ounce. In the wake of the Fed’s recent decision to stand pat on interest rates and gold’s subsequent jump today, here are 3 reasons to avoid gold, both as a physical or paper holding, apart from a very small percentage of a well-balanced and diversified passive or lazy investment portfolio:

  • It’s a highly emotional and psychological asset
  • There’s no historical evidence that it hedges well against any risk
  • It has very little practical use

The yellow metal is a highly emotional, psychological asset. Its pricing doesn’t comply with a supply and demand structure as does oil pricing, for instance. If all oil-producing nations continue pumping out oil despite an existing supply glut, and if the global economy continues to struggle with economic activity and recovery, then we know prices will stay low because supply currently outweighs demand. At what exact price level oil will find itself at as time goes on, who knows, but that’s not the point; we know oil won’t leap up in price anytime soon unless there’s new evidence that it’s being used much more heavily. When we invest in the equity of a company, we do so thinking that the corporation is going to grow or at least pay us dividends and otherwise protect the value of our investment while providing us a return. With gold the commodity, there’s no such relationship. Interestingly enough, as authors Erb and Harvey point out in their scholarly paper The Golden Dilemma (2012), nobody really knows how much gold exists above ground (already mined throughout history), nobody really knows how much exists below ground yet to be mined (and changes in technology can change estimates), and the production of gold has been rather constant year upon year. Indeed, its production is rather insensitive to its price. This means that in spite of what has already been produced, what could be produced, and its going price, mining companies continue to produce an amount of gold within a certain range. As they note, “Remarkably, the new supply of gold that comes to the market each year hasn’t substantially increased over the past decade even though the nominal price of gold has risen fivefold.” Doesn’t that seem strange?

What’s more, of all the three primary uses of gold (jewelry, investment, and technology), only investment in gold seems to have a strong price elasticity of demand, and a positive one, at that. Jewelry has a negative price elasticity of demand but it’s not that strong, and technology demand seems to be price inelastic. What this means is that demand for gold for making jewelry goes down slightly as the price of gold increases, which makes sense as the raw material, and hence the products, become more expensive and some customers are simply priced out as they can’t afford it anymore. Technology demand doesn’t really seem to change much no matter the price; whatever gold is required to make technology products, it is purchased as needed, no matter how expensive the yellow metal is. However, as for investment demand, well, as the price of gold increases, so does the amount of investment. Think about that. As the price of gold goes up, more people invest in it, chasing positive returns on their investment that others have already realized. This is officially known as momentum investing and while some would argue it’s a legitimate trading method, others might say it’s just a psychological and emotional trade (“I want to make money too!”); it’s just a bunch of lemmings heading toward a cliff.

As for buying physical gold coins, you can’t really spend them easily. Walking into a grocery store to buy some lettuce with a gold coin will get you some strange looks and no lettuce. So what does buying gold buy you? Psychological peace of mind in case the world falls apart. The value of that peace of mind is extremely personal and doesn’t translate well to commerce markets. Besides, in that apocalyptic world, will you finally be able to easily spend it for those things you need? How will you and your trading partner establish the value of a gold coin in the absence of currencies, governments, banks? And the next transaction you have with someone else, will they agree to the same value? Probably not. Besides, in such a world seeds could be of more value, or plain survival know-how – hunting and gathering, shelter-building, plant identification, and so on. Furthermore, investing in something for emotional or psychological reasons is not sound trading behavior. You may buy gold for psychological and emotional reasons because it brings you peace of mind, but how will you feel if gold goes down in price? Will you still feel psychological or emotional well-being, or will you feel stupid?

nominal price of gold

Historical gold prices since gold has been a tradable asset (in nominal dollar terms). Source: MacroTrends.

From The Golden Dilemma, we also learn that historically speaking, gold has not hedged inflation or general crises consistently nor frequently. Basically, gold may or may not be a good store of value in bad times. That’s not the kind of hedge to invest in, that’s gambling. The authors examine various situations and time periods and find no correlation between rising inflation or even hyperinflation and rising gold prices. As for general crisis hedging potential, there always seems to be a crisis occurring in this world. Has gold ever been the answer to any of them, an investment savior? How have we seen gold behaving as a safe-haven investment recently? When the stability of the entire European Union as an organization was threatened by the failure of Greece’s economy and potential exit, gold actually declined in value. As concerns over China have grown, the price of gold really hasn’t. With the worst refugee crisis (Syrian) in history since WWII underway, the price of gold is cooling once more. Frankly, gold doesn’t seem to be a reasonable answer to any crisis. Will it save us from a climate change crisis? An overpopulation crisis? A lack of clean water crisis?

Take the following story from The Golden Dilemma on the Hoxne Hoard and how poorly gold may serve as a safe-haven investment in tumultuous times:

A possible second condition for a safe haven [investment] is that during times of stress it should be possible to access the safe haven asset. Consider the famous Hoxne Hoard which is currently on display at the British Museum. The Hoxne Hoard is an example of what can happen when trying to make a safe haven investment. The Hoxne Hoard is the largest collection of Roman gold and silver coins discovered in England. Evidence suggests that the hoard was buried sometime after 400 A.D. by a wealthy family seeking a safe haven for some of its wealth. The 5th century A.D. was a time of great social stress and political turmoil in England as the Western Roman Empire unraveled. The fact that the hoard was discovered in 1992 means that the family failed to reclaim its safe haven wealth. Indeed, the Hoxne Hoard is an example of an “unsafe haven”.

Finally, gold has little practical use. It’s mostly used to make jewelry, then as something to invest in, and then a distant third as a manufacturing input for technology goods. You can’t really spend it in your neighborhood, it’s not that easy to borrow against, you can’t easily transfer its value electronically to pay bills or purchase things. People who inherit it don’t know what the hell to do with it, while people who purchase it in coin form do so knowing full well they are not planning on spending it in their daily lives, but rather under wild-emergency, black-swan circumstances. I reassert that in such times, there will be other things of much greater value than gold coins. Besides, if you own gold, you may see it confiscated by your government. It has happened in the US before. And anyway, let’s face it, gold is heavy and difficult to haul.

As an aside, what about central banks, you ask? Well, it’s true that some of the world’s central bankers continue to buy gold, although no country is on a gold standard anymore and some countries are even net sellers rather than net buyers. Some net buyers buy gold, year after year, no matter the price, probably because it’s what central banks do, something they agree to doing, because it preceded fiat currencies and can make financial negotiation (whatever the reason – debt, trade, etc) between governments possible given the failure of a major currency or the fiat system altogether, or because it maintains faith in a currency issued by a government that owns gold. Who really knows, though. Ben Bernanke has been quoted as simply stating that it’s because of “tradition”. But individual currencies are “failing” all the time yet eventually they resurface, and if the whole fiat currency system fails, you’ll want to be able to take care of yourself rather than own gold for reasons already mentioned (apocalypse). For those of you who believe that cash will be trash, including the USD, keep in mind that the US maintains the largest store of gold in the world and it has been suggested that amount constitutes some 70% of the country’s reserves.

One sure thing about gold is that it is poorly correlated with other assets. Its use as a means of further diversifying a well-balanced lazy portfolio is definitely worth something. If it leads to an increase in the value of your portfolio, fantastic, but don’t count on it as some type of infallible lifeline when disaster strikes wide. Better off knowing how to feed and shelter yourself, and meet your other most basic of needs first.