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

Pros

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.
   

Cons

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.

Current Opportunities for the Defensive Investor

A friend recently asked me whether or not to sell some stock options from his employer and what to do with the proceeds. This is a tough question to answer because each one's situation is different. So I answered him first with a set of premises that I believe are universally true and are to be followed as general guidelines at all times. And then, I mentioned a few twists for taking advantage of the current situation as well as some precautions.


Investing Premises for the Defensive Investor

1. Emergency Fund. Always have at least a six-month fund in cash or ultra-safe investment for eventual emergencies.
2. Money needed in less than five years should not be in stocks.
3. Extra money not needed within five years should always be at least 25% in stocks, typically more. A 50-50 allocation between stocks and bonds is a good, no-brainer choice.
4. Inflation is the enemy. Be weary of anything that ties up money for a long time and has no chance of benefiting during inflationary times. Inflation is always around, sometimes to a larger degree than others.
5. The taxman is the enemy too. All things equal, paying less taxes is always better. Avoid taxes as much as legally possible. Delaying taxes is often an option, especially if one can choose between taking a profit now or later. Typically, avoid taking taxable profits at the end of the year, since taxes will be due sooner than if you took the profits early in the year (say, selling in November gives you 6 months until tax collection time in April, while selling in January gives you a year and four months to enjoy the money -- exceptions abound, so consult your tax advisor for details).
6. Avoid over-relying on your employer. If you depend on employment income for a living, loading up on your employer's stock significantly increases the amount of risk you take. Sell those stock options when it makes sense. If your spouse works there too, that's even more risk, you probably don't need to hold any employer stock at that point.

As they are, these are general guidelines to be observed at all times. What does that mean right now, in terms of actionable items and the current situation? Let's take a look at the current investing scenario.


Current Investing Situation

1. Low interest rates.  Money market and savings accounts yield next to nothing, so investors will lose money to inflation over time.
2. Threat of higher inflation in the near future. With money printing and inflation officially at its lowest point in years, it's guaranteed that the only possible outcome in the future is higher inflation.
3. Devaluing of the dollar. With the recent threat of collapse of american financial institutions, the rest of the world is scared of the dollar -- China is buying gold and Saudi Arabia is allegedly selling oil in Euros, not Dollars. Combined with fear of higher inflation, holding US Dollars doesn't seem like a good call right now.

Intersecting the current investing situation with the investing premises for defensive investors, what is my friend, a defensive investor, to do?


Current Action Items for the Defensive Investor

1.  Get an emergency fund in place. My friend should sell enough of his stock options and get that emergency fund in place. A good place to park it is in Vanguard's Prime Money Market Fund or a muni fund from his state if he's in a high tax bracket. In his case, the California Muni Market Fund will do it.
   
2. Diversify away from the dollar and hedge against inflation. With the funds my friend will need in the next 5 years, he should put them in inflation-protected places. My favorites are TIPS funds such as Vanguard's Inflation-Protected Fund and a CD of a basket of strong currencies, such as Everbank's Commodity CD, which contains 25% of each Australian, Canadian, New Zealander and South African currencies. Another good choice is the Debt-Free CD which has among others the Swiss Franc and the Brazilian Real.
3. Invest for the long-run. With the rest of the money he won't need in the next 5 years, I told my friend to invest at least 25% in stocks, but possibly even more. A good choice is to go 2/3 stocks and 1/3 bonds with the Wellington Fund. To be more aggressive, I'd allocate 70% to Wellington and the rest into a Total International Stock fund or equivalent.

Regarding his employer's options, I told him to lock-in most of his gains now to start the above plan right away and to keep only a small portion for future appreciation, since his options vest continuously and are replenished by his employer annually (there are more where these came from).

My advice for Entrepreneurial  Investors would only be slightly different, and it would also include to a large extent the same defensive investments outlined above. The difference between the two types of investors is the amount of time and interest they have to devote to their investments. As such, a defensive investor should refrain from picking stocks and engaging in short-term arbitrage transactions. And every investor, seasoned or not, had better stay away from market-timing folly and listening to financial commentary in general.

Disclosures: I own shares of some of the funds mentioned above: VGTSX, VCTXX, VIPSX and the Commodity CD. I did not receive any compensation for mentioning the names or products of any of the companies cited above.