Today I’m going to let you in on an ugly truth about gold.
All the naysayers are right. Gold is a bad vehicle for generating returns.
Here is the rub, though; gold bugs are right too. Gold is a great investment.
Hear me out and I’ll show you how this is not a contradiction at all. In fact, these two truths complement each other quite well.
They may not mix well, but with only one or the other, you’re stuck with something incomplete.
Wondering what in God’s name I’m blathering about? Let’s dig into the what and why.
Two Standards
There is one fundamental reason these statements seem at odds with each other.
We’re talking about two very different standards assumed by the pro- and anti-gold camps.
On the anti-gold side, the focus is on returns, namely those from equity investments in stocks in particular. These investments are shorter-term by nature, and use the dollar as a fixed variable.
Stocks are measured as a return that is only determined by how much they cost in dollars now, versus how much they cost in dollars when the investor bought.
In other words, the dollar doesn’t change at all, so having a higher percentage return trumps all for growing wealth or turning a profit.
Too bad over a longer term this assumption is completely wrong.
After all, every currency you’ll use to invest in anything is fiat. It is backed by a wink and a smile, two things only as good as the person behind them. If you measure relative value, it is far from fixed.
To me, gold is about a currency-agnostic investment. It is the ultimate rainy day fund within a portfolio.
That portfolio is there to steadily grow wealth, with different ratios of holdings at different times based on what is happening in my life, and in the broader market.
In this sense, the two sides of the gold argument are correct, but we’re talking apples and oranges here.
Visualizing It
I could go on and on, but a picture is worth a thousand words. This is the heart of what we’re talking about:
The yellow line is the value of gold over the last century in fixed November 2014 dollars. This is the type of outlook the anti-gold camp holds.
The dollar is a static unit of wealth, with little regard for the long-term effect of currency devaluation due to their short-term investments.
The green line is the value of gold in nominal dollars. The value of gold for any particular date is how much it would cost you then in that day’s dollars.
As time inevitably flows from left to right, dollars steadily decrease in value, driving up the price of a troy ounce of gold in terms of dollars.
Only the years when gold prices were pegged to the U.S. dollar by international agreement bucked this trend, and boy did that change when Nixon shocked the world by dropping dollar-to-gold convertibility.
Bringing Them Together
There is a strong reason to combine these views, though they seem to mix about as well as oil and vinegar.
Long-term inflation is pretty easy to grasp, but to see where owning investments that are not tied to any single currency truly pays off, let’s look at Europe’s whipping boy, Greece.
Right now, Greeks are stuck under capital controls. Money can still move freely within the nation, but international transactions and ATM withdrawals are capped at 60 euros.
To make matters even worse, there is talk about a Cyprus-style seizure of deposits to keep banks liquid, where 30% of accounts holding over 8,000 euros would be taken.
Even within the near-draconian limitations, gold is an easy proxy for a kind of wealth insurance from a possible Grexit.
Here is how it would work: Since purchases are still allowed in-country, Greeks can purchase gold until their bank account is under the 8,000 euro limit.
The tax, or “bail-in” if you prefer absurd euphemisms that are being used, would be dodged, along with inevitable and immediate devaluation of the newly emergent drachma if the euro is no longer the official currency.
Once the dust settles, that gold can be sold back into the market.
The price of gold will barely change, if at all, for non-Greeks. Gold is sold for different amounts of different currencies based on the relative values of the currencies after all.
Yet, this is a make-or-break issue for Greeks. Their wealth will shift dramatically downward in a Grexit if it is kept in currency-dependent equities or as cash.
First there is the 30% haircut. Then there is the inevitable devaluation of the drachma. Conservatively, we’re looking at a 40% to 50% drop in real wealth if it is purely held within euros in Greece in the worst-case scenario.
Be Prepared
Even if Greece magically lands a deal, currency controls are lifted, and the country stays within the eurozone, the gold can be converted back into currency.
The buyer may lose some money by buying at a premium and selling at a discount if a deal happens tomorrow, but all forms of insurance come with a price that is trivial compared to the worst-case scenario.
Equities are a critical source of returns for investors. There is no way around this fact, and you wouldn’t be reading this newsletter if you weren’t interested in using equities to build wealth.
Yet at the same time, there needs to be a hedge. Gold is it.
When there is an uncertainty, the markets are dropping, the government picks the bankers over the people, and currencies are tanking, it is irreplaceable and indispensable.
Think of all the “what ifs” too:
- What if the Greek government limited precious metal purchases?
- What if all transactions were halted through banks, protecting them and starving you?
- What if no one saw it coming until the last second?
This is why it is a good idea to own gold now. These things creep up on people, and when things get ugly we’re helpless when we’re stuck using government-mandated legal tender.
Just a couple weeks ago, the markets were betting that capital controls, eurozone removal, and default were absurd and were widely bet against and categorically dismissed.
Make some money in equities and keep at it, but don’t forget that our investments are always on shifting ground, or forget how quickly things change.
That is why you should hold some wealth in gold at the same time.
