A Place for the Shiny Metal in a Value Investor's Portfolio

I'm often asked about whether I like gold as an investment medium.

Personally, I don't use gold and have never used. But that doesn't mean I don't believe there is a place for gold in one's portfolio. There is. Let me explain by stating a few true facts that can be confirmed with a bit of your own research:

Pros and Cons of Gold

  1. Historically, over long time periods, gold mostly retains its purchasing power.
  2. Gold doesn't go bankrupt, doesn't overstate earnings, doesn't write-down anything (its weight, for example).
  3. Physical ownership of gold cannot be confiscated by law or by electronic methods; force is required to take gold from someone.
  4. Gold is universally accepted.
  1. Gold doesn't pay a coupon or dividend.
  2. Gold can't cut costs, become more effective, increase earnings, expand market share or come up with a great new idea.
  3. Gold can't take advantage of acquisitions, market opportunities or low interest rates.
  4. Gold is hard to value. There's little industrial utility for gold, so demand is mostly speculatory and fear-driven.
Basically,  what this all tells an investor is that 1) gold provides little in terms of a decent, predictable, long-term return but that 2) gold is a good store of value for times of political and monetary uncertainty.

Let's break it down in parts.

Little upside

As a commodity, the price of gold depends on "the market" and there is little in the way of assigning it a fair value. Bonds, on the other hand, can be assigned a value given a discount rate, inflation, maturity, credit quality and coupon rate. Stocks, though harder to value, can be valued independently of their market price too. Gold cannot.

As such, how can one "invest" in gold and expect returns from it, without having a crystal ball?

Store of wealth

On the other hand, gold has historically(*), in modern times (last 100 years or so) held its value over time.  Due to its fungibility and international acceptance it's a good medium of exchange ("currency") to have in times of trouble, war, economic instability, inflation,  and maybe even deflation. This mostly applies to physical gold held close to the investor, not in a vault or via proxies.

Gold is, then, a good hedge against inflation over long time periods.

How to use gold?

So how should an investor use gold? To me, it only makes sense to have gold as part of one's cash reserves. As I've said before, every investor, experienced or not, should have at least six months worth (more for increased safety) of living expenses in readily available currency such as money markets and savings accounts. And in my view, part of this reserve can be held in physical gold (other commodities may also qualify, but let's focus on gold here).

If one is fearful of high inflation, political or economic instability, then increasing this allocation to a year or more makes sense. It also makes sense that this extra reserve be in gold.

Currently, I don't own gold and have no intention of buying it anytime soon. The time to buy gold is when everyone is talking about prosperity, peace and low inflation. And even then, the role of gold should be limited to that half-year to a year reserve of readily available "currency", for emergencies.

* Appendix: How well does the value of gold really hold up?

I couldn't help but try to find what an ounce of gold could buy many centuries ago. Perhaps the historians could help? So, here's my uber non-scientific, back-of-the-envelope-ish analysis.

According to this site, prices in ancient Rome during the 6th century were as follows:

1 donkey = 3-4 solidii
1 lb of fish = 6 folles

Now, some units:

1 solidus = 1/72th of a half pound of gold = 226.79/72 g of gold = US$ 101 (@ 1 troy ounce = US$ 1000)
1 folle = 1/180th of 1 solidus = US$ 0.5626

Hence, we get the following prices in today's USD:

1 donkey in ancient Rome = US$ 303-405 today.
1 lb of fish in ancient Rome = US$ 3.375 today

But in reality, we see the following prices currently:

1 donkey today = at least US$ 500, sometimes close to $3000 (sources: http://www.equinenow.com/donkey.htm, http://www.littlefriendsranch.com/Donkeys%20for%20Sale.htm)
1 lb of fish today = US$ 15-20 (source: http://www.allfreshseafood.com/p-tilapia-fillet.htm)

The interesting thing is that the prices are in the general ballpark despite the centuries that have gone by. Neither the fish cost a tiny fraction of a penny nor the donkey was found to cost a trillion dollars.

So, if that's even close to correct (which I can't confirm), it means that gold mostly retains its value, but "inflation" can catch gold too -- after all, it can be mined and thus diluted.  Also, despite all the increased efficiency in farming techniques, raising donkeys and fish didn't seem to get much cheaper over the years but instead have appreciated in gold terms.

This analysis, however, is mostly for entertainment value as I can't verify the validity of the prices above. Take it for what it's worth.

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