Gold! Gold! Gold! It seems you can't look anywhere these days without someone talking about gold and how you should melt down your jewelry and sell it or buy some to protect your portfolio. Many websites, newsletters, talking heads, and doctor's lounge conversations advocate investing a large percentage of your portfolio, or even all of it, in the shiny stuff. “And if you're not going to buy gold, buy silver!” Let my voice be one of caution, prudence, and moderation with respect to this. First, some background information.
Looking at that chart from kitco.com, it becomes pretty obvious why you hear so much about it these days. In the last 9 years, the price of an ounce of gold has risen from $350 to nearly $1600. Silver doesn't look a whole lot different.
In 2002 the price was $5 an ounce and it is now about $39. If you had invested in gold in 2002, you would have quadrupled your money. Silver? You would have nearly multiplied your holdings by 8. So should you invest in gold and silver? Yes, but you should have done it in 2002 not 2011! Trees don't grow to the sky.
How Do You Invest In Precious Metals?
There are three main ways that people invest in precious metals.
First, you can buy bars or coins and store it in your house or safe deposit box. It won't be paying you any dividends, there are significant transaction costs (especially if you don't know what you're doing), and it will cost you money to store and protect it. To make matters worse, when you sell it you'll pay tax at the collectibles rate, rather than the capital gains rate. Proponents of this method argue that you can use your gold to buy things you need in an apocalyptic scenario. Personally, I think you'll find that canned food, assault rifles, and plenty of ammunition will go a lot further in that situation. I guess I just have a hard time imagining slicing a sliver off of a gold bar to trade for some gasoline.
Second, you can buy the newer ETFs GLD and SLV. These ETFs will buy, sell, and store the gold for you. Like any ETF, you can buy and sell them any time the markets are open. Unfortunately, your gains in these ETFs are also treated like gains in physical gold, so you'll have to pay higher tax rates. If held in a tax-protected account such as an IRA, you obviously avoid the problem. You do get to avoid the sales taxes you'd pay buying physical gold though. The ETFs do pass their costs on to you in the form of an expense ratio (as well as any commissions and bid-ask spreads when you buy and sell.) The expense ratio for GLD is 0.4% and for SLV is 0.5%. You get the benefits of investing in precious metals while avoiding many of the hassles. Many speculate that the development of these ETFs has been an important part of the dramatic increase in the price of these commodities since their 2004 debut. Just as the new development of on-line trading helped fuel the tech stock bubble in the 1990s, perhaps the development of precious metal ETFs is fueling the precious metals bubble now.
Last, you can buy the stocks of companies whose prices are closely tied to the movement of precious metals. Vanguard has a precious metals fund available at a reasonable cost, although it only holds 49 stocks and many of them have little to do with gold. There are ETFs that contain just the stocks of gold miners such as GDX that will expose you more to the price of gold, for better or worse. The benefit of buying the stocks of these companies is that they pay dividends, unlike the physical gold or the gold ETFs. They are actually working at building a business, and as a shareholder, you get to share in the profits (and losses.) The Vanguard fund has averaged over 20% a year for the last 10 years.
Benefits of Investing in Gold
The benefits of investing in gold are several. First, every now and then, like the last 6 or 8 years, the price of gold dramatically climbs. If you own it at these times, you are spectacularly rewarded. Second, when people fear inflation (whether it is present or not) they tend to rush into commodities, further inflating their price. Third, no one can print gold. You may have noticed that it is often in the interest of politicians to print money. Fourth, a volatile asset class, even one with no positive long-term after-inflation returns such as gold, can provide a “rebalancing bonus” if you rebalance between it and your other holdings in a consistent, unemotional way.
There are also problems with investing in gold. If you look at the historical prices, it can go down just as quickly as it goes up. Go back up and look at the chart above. Imagine buying gold in 1979. By 1982 you've lost over 1/2 your investment, and it took 25 years to get back to the same place, and that's without counting inflation. I know very few investors with the patience to wait that long for an investment to recover. Volatile prices and long periods of underperformance do not make for restful sleep. Unless you own the stocks of gold mining companies, gold really doesn't pay dividends. Historically, a large percentage of the gains in the stock market are due to dividends. Ignore them at your peril. Gold also doesn't necessarily protect you from market declines. Remember when the stock market crashed in 2008? What did GLD do? It fell from $95 a share to $71 a share, a 25% decline, right along with the rest of the market. Hardly a safe refuge in a storm.
However, my main concern isn't buying gold. It is buying gold now. The classic signs of a bubble have arrived. We have the development of a new technology, gold ETFs. We have a rapid rise in price. A larger and larger percentage of the population has already been drawn into these investments. These ETFs now hold more gold than the central banks of most of the countries in the world, combined. There are infomercials on all night telling you how to buy gold. There are dozens of new books and websites out there to facilitate investors learning about and investing in precious metals. JFKs father noted that he knew to get out of stocks in 1929 when a shoeshine boy gave him a stock tip. Ask the housekeepers at your hospital about gold. If they know anything about it, or worse, have already invested in it, what does that tell you?
Now, I don't know what gold is going to do in the short term. I don't even know what gold is going to do in the long term. But I do know this- you will NOT continue to double your money in gold every 4 years indefinitely. If something cannot “go on like this forever”, it won't. Before jumping in, ask yourself if you aren't already a little too late to the party, and if you've been at the party for a few years already, ask yourself how much wilder it can get before the cops show up.
Performance chasing can do some real damage to your portfolio. A few years ago I decided I wanted to add REITs to my portfolio. I had convinced myself of the diversification benefits to my portfolio. I added a small slice, about 7.5% of my portfolio, in November 2006. I bought the Vanguard REIT Index Fund at $25.87 a share. At first it went up, and by February my shares were worth $28.93, a quick 12% gain in just 3 months nearly 50% if annualized!). I was pleased. Then, over the course of the next 2 years, I lost over 75% of my investment as the price dropped to $7.01 per share in the 2008 crisis. Now, I did a few things right here. I only put a small slice of my portfolio into this volatile asset class. I was also committed to it as a long-term part of my portfolio. I understood the theoretical benefits for it, and I knew that diversification meant that some parts of my portfolio could and would do worse, even markedly worse, than other portions. As the price dropped, I rebalanced the portfolio, over and over and over again. In fact, as the market was hitting bottom, I was continuing to buy. Since the market recovered rapidly, and thanks to buying a lot of shares at low prices, my overall return in REITs has been over 8% a year from 2007 to now. But I am still quite underwater on that original $3000 investment as the current price of that fund is only $20.38. I would have been much better off buying REITS when everyone else WASN'T talking about them, despite their very real long-term benefits to a portfolio.
Should You Invest In Gold?
So my advice is this: Precious metals are NOT a required part of a portfolio. The only gold I own is on my finger. You can do just fine your entire investing career without ever buying a gold miner stock, a gold ETF, or bars of the shiny stuff to hide in your fallout shelter. If you feel you want to invest in gold, use only a limited portion of your portfolio, no more than 5-10%, and plan to hold it for a very long time. Set the percentage of your portfolio you wish to hold, write it down in an investing policy statement, and when the price drops dramatically (as it inevitably will), buy more. If the bubble continues upward for a few more years, and your holdings then exceed the percentage you set in your policy, SELL IT, and rebalance into your other portfolio holdings. Don't make your retirement dependent on the whims of the gold market, and certainly don't make your investing success hinge on your ability to predict the future. I don't have that ability and neither do you. Market-timing and performance chasing are a losers' game.