All That Glitters Isn't Gold

December 22, 2008

While gold's provided a positive real return over the long term, the price movement is too volatile to be an effective inflation hedge.

Whenever equity asset classes experience bear markets, investors seek out safe havens for their investments. This is especially true in times of financial or political crises.

One whose popularity runs in cycles, with short bursts of enthusiasm or "frenzy" as the price soars, followed by long periods of it being ignored, is gold. And while the price of gold has fallen from its peak of over $1,000 in March 2008, we can still say that it is in the "frenzy" stage.

The main argument made by advocates of gold is that they believe that it is a good hedge against inflation. For the period from 1935 (when the price of gold was fixed at $35 an ounce by the Federal Reserve) through October 2008, gold did provide a positive real return of 0.6 percent. Unfortunately, not all individuals have horizons of 73 years. We need to consider more realistic investment horizons. This is especially true for retirees (for whom 73 years would be far greater than their horizon), or those nearing retirement, as they face the greatest risk of inflation negatively impacting their lifestyle. We address that issue by considering the period since 1981—the last time there was a "frenzy" for buying gold.

In 1979, inflation peaked at a rate of 13.3 percent. That was followed by an increase of 12.4 percent in 1980. The price of gold rose as the fear of inflation increased. While we admit to a bit of data mining, the following example demonstrates that gold is not a good inflation hedge, unless perhaps your horizon is "infinite."

Let's assume that to provide a hedge against future inflation an investor decides to purchase gold at the end of 1980 with the price at $641 an ounce. Over the next 27 years (1981-07) inflation rose at an annualized rate of 3.4 percent. If gold was an effective hedge against inflation its value at the end of 2007 should have been at least  $1,528. Yet, it was worth just $833 (an annualized return of just under 1 percent).

In other words, an investor in gold experienced a reduction in purchasing power of 2.4 percent per annum, or a cumulative loss of purchasing power of about 55 percent. For an investor who was unlucky enough to purchase gold at its peak of $850 an ounce on January 21, 1980 (as some undoubtedly did), the inflation-adjusted price would have had to been in excess of $2,300 by the end of 2008. If gold can provide negative real returns of that size over almost a thirty-year period, it cannot be considered an effective hedge against inflation.

Even worse is that our example does not consider the costs of investing in gold.


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