Monday, January 24, 2011

Only in a perfect world will I invest in gold

You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value? –Warren Buffett

Gold has done really well over the past decade, and the gold bugs believe that the price of gold will keep on climbing. But unless the world becomes perfect and we can all walk on sunshine, I don’t think I’ll be investing in the precious metal. In this article, I will be talking about the reasons why I stay away from gold.

I can’t value the damn thing

The main reason why I don’t want to have anything to do with gold is the fact that I simply can’t value it (maybe some other people can or think they can, but I can’t). Unlike shares in a company that generates profits and pay dividends, or bonds that pay interest, gold just sits there doing nothing. And because gold doesn’t actually earn any money, there isn’t any cash flow for me to discount back to the present to arrive at a value.

If I can’t value something, how would I know whether or not I’m getting an attractive or at least a fair deal? Take stocks for example, if I know the value of a company, I can buy the stock if it’s undervalued, and be completely ok if the price of the stock fell, so long as its fundamentals remain intact, as it’s creating real value for me by giving me income or reinvesting profits for my benefit.

With gold, I can’t tell how much of the price reflects real value, and how much represents speculative greed. I could buy gold one day, only to watch its price fall significantly over a few months, and be stuck with paper losses for years (it isn’t too hard to imagine, as gold did crash before) while my gold holdings just sit there doing absolutely nothing. I am well aware that the price of Gold could keep on climbing, but I would rather invest in an asset that creates real value for me than invest in something that people might value highly and demand more of, but doesn’t create any real value.

While a case can be made for using the cost of production of the commodity or the inflation-adjusted price of the commodity to help us value that commodity, gold isn’t exactly like any other commodity in the sense that a lot of the demand for gold comes from investors while most of the other commodities are used mainly for industrial or commercial purposes. The problem comes when these aspiring King Solomon gold bugs find out that gold isn’t all that it’s cranked up to be, and start dumping the precious metal in favor of other asset classes that actually generate profits or income.

I know the fed is printing money, I know that all the stimulus could very well lead to high inflation in the future, and I know all these things could cause gold to soar. But I personally think that it’s gambling to buy gold in the hopes that its price will rise because we will experience high inflation or a significant decline in the dollar. In my book, investors can only hope for returns when the assets they invest in actually returns to them cash or reinvest the investors’ share of the profits for the investors’ economic benefit.

A sometimes volatile store of value

People say that gold is a store of value, and over the long-term, that appears to be true. The thing is that gold can get overvalued, and like any other asset that has gotten too far ahead of itself; the price of gold will probably come crashing down (assuming of course that gold is overvalued, I wouldn’t know if it is, as I can’t value the damn thing).

If we live in a perfect world where there isn’t any risk of gold having any volatile price swings, then yes, I will consider replacing my cash  holdings with gold, as gold holds its value and cash don’t. But because there is the risk that the price of gold can decline, I can’t use gold as a currency or as a proxy for cash, as I don’t want to be in a situation where an attractive investment opportunity presents itself, and I have to sell my gold holdings at a significant loss or take a pass on that opportunity.

If I wanted to preserve my wealth, then maybe I can consider gold as a long-term investment. But why aim to only preserve my wealth, when I can just dollar cost average in a low-cost index fund, and very probably get a decent growth in my wealth over the long-term?

Historically, gold produced pretty lousy returns while businesses (both stocks and private businesses) have been the greatest generators of wealth. This makes sense as gold just sits around and do nothing while businesses pay out dividends and reinvest profits so that they can generate even more income for their shareholders in the future.  

I’m of course not telling you to avoid gold too, just letting you in on why I personally think gold makes for a bad investment. But maybe I’m missing something here; maybe gold can really be a good investment. If you think I’ve missed out on something in my evaluation of gold as an investment, or if you have any questions, please feel free to comment.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.