What is Gold?

Jason Zweig has a couple of good pieces in the WSJ today on gold (see here and here). Jason is not a big fan of owning gold in a portfolio and I generally agree with him. However, I don’t completely agree with the description of gold as a “pet rock” and I think it detracts from the point he’s trying to make. So let me see if I can make a similar point from a more empirical perspective.

I like to work from what I think is a form of rigorous empiricism. I tend to think like an engineer so I always ask how things are constructed before asking how they can be used. For instance, a stock is a financial instrument giving the owner a claim on a corporation’s future profits and since we reside in a capitalist system a fairly high probability bet is that corporate profits will rise over time which will make an aggregate index of stocks more valuable across long periods of time. A bond is a slightly different type of financial instrument (usually) giving the owner a fixed income stream as defined by the terms of the contract. This instrument will generally underperform stocks because the income is a current expense for the company which reduces profits. Assuming the company is using the bond to finance growing output it’s safe to assume that stocks should beat bonds over long periods of time because stocks give you a claim to the residual income that bonds finance.

Those are really simple, but fairly empirically grounded understandings of some of the instruments we use in the financial system. Gold, however, is very different. So, what is gold?

• Gold is a non-financial asset. A liability to no one and an asset to the holder.
• Gold is a commodity.
• Gold is traditionally used as money, however, in a modern monetary system it is a fairly poor form of money because it is not easily transferable and tends to be illiquid.
• Gold has real economic utility as an industrial metal. In Q1 of 2016 43% of the demand for gold was due to its use as jewelry and industrial purposes.
• Gold is widely used as an investable assets. In Q1 of 2016 57% of its demand came in the form of investments and Central Bank purchases.¹

So, while gold is primarily used as an investable asset it is heavily used for other purposes such as jewelry, industrial purposes and Central Bank management. But this doesn’t answer how gold fits into our portfolios so let’s dig a little deeper.

The primary reasons people invest in gold are its supposed inflation protection, currency hedging and crisis protection. Because gold has been used as a form of money for thousands of years it is widely viewed as a form of protection against a collapse in fiat monetary systems. This is likely irrational however, since reverting back to a gold based monetary system would likely involve the complete collapse of our modern monetary system. In that case, having stable money will be the last of your concerns. After all, in this Mad Max world the man with the most gold won’t get the most bread. The man with the most lead will get the most bread.

Regarding its properties as a currency or inflation hedge the evidence is also suspect. The definitive study on this comes from Erb and Harvey in 2013.² They found that gold is a good very long-term inflation hedge, however, it’s a highly unreliable inflation hedge in shorter more relevant time periods (such as a 20 year time period, the most relevant period to the average investor). They also found that gold is not a reliable currency hedge since the modern fiat currency system is a zero sum system that can only cease to exist in the case of a total collapse. They also found that gold is not a very reliable crisis hedge since its performance in periods such as the 2008 financial crisis was, at best, uneven. So, gold is an imperfect hedge against many of the things its most ardent proponents claim it achieves.

But does this make gold a bad investment?  Not necessarily. As noted above, much of gold’s demand comes from its uses outside of mere investment or speculation. So there is an inherent utility in gold as a commodity. On the other hand, its primary use is in the form of investment giving its price a highly speculative aspect. This makes gold a strange combination of a useful commodity and something like a collector’s item or a piece of artwork. As a result of this gold’s future value is contingent not only on rational demand, but also potentially irrational demand. That is, collector’s items or pieces of artwork are largely greater fool games. The only way you can sell at a higher price is to convince a greater fool that that asset is worth more than you paid for it. Thus, its value is primarily in the eye of the beholder and not in some empirical property relating to its economic utility.

In terms of how gold might fit into a portfolio I think we need to be more specific. You typically wouldn’t want to own commodities just to own them because commodities are cost inputs in the capital structure and should therefore not be expected to outpace inflation over long periods of time. You buy commodities to create something of greater value (my phone, for instance, has some small amount of gold in it and Samsung sold it at a mark-up over cost). But this does not mean that gold isn’t valuable for the same reasons that people believe artwork or other collectibles are valuable. But if we’re going to categorize gold as a part commodity and part collectible then it would be unwise to have an excessive amount of our portfolio exposed to this asset since its future value is largely contingent on the greater fool theory. Therefore, this doesn’t mean gold can serve no purpose in a portfolio. But I think we should be clear about what we’re buying when we buy gold. We’re buying something that:

• Isn’t a good form of money.
• Won’t necessarily protect you against currency crisis, inflation or financial crisis.
• Has real economic utility as a commodity.
• Has properties similar to collectibles and artwork since its value is largely derived from the belief that it will be more valuable in the future.

I think it’s prudent to view gold as something similar to a collectible with an element of real underlying economic utility. The commodity aspect makes it a poor investable asset on its own. However, because it has properties similar to artwork or collectibles it could serve as a good investment since people are likely to believe that it has certain special properties unrelated to its economic utility. On the other hand, like artwork and collectibles I would be very cautious about viewing this asset as something that should comprise a substantial portion of your total assets. The degree to which this asset’s future value relies on greater fools is not a prudent way to construct a savings portfolio.

¹ – Source: World Gold Council.

² – The Golden Dilemma, Financial Analysts Journal.