Stephen Foerster is a professor of finance at the Richard Ivey School of Business at the University of Western Ontario
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Winter Olympic fans worldwide will soon be encouraging their athletes to "Go for the gold" and to reach for that record-setting performance. In contrast, "Go for the gold" as an investment strategy may be the worst course of action for investors today, if history is any guide.
The recent rise in gold prices can be attributed to a number of factors, including the weakness of the U.S. dollar relative to other major currencies, such as the euro, since gold is commonly quoted in U.S. dollars; concerns over higher inflation on the heels of global government stimulus packages; and India's recent move to acquire $6.7-billion (U.S.) of gold and an expectation that other central banks will follow.
But another possible explanation is based on "the greater-fool theory" whereby investors are buying gold on the expectation that the price will rise and they will be able to sell at a higher price to "a greater fool." A related justification for buying gold is the belief that gold always provides a "safe haven" in troubled times such as the recent financial crisis. But such reasoning relies on investors to believe for the sake of believing.
Contrast this with investing in stocks, whereby you are taking an ownership stake in a company and the ownership gives you a share of the future cash flows that the business is able to generate. The price of a stock should increase as the future prospects of the company improve and for most established firms - particularly Canadian banks - you can expect to receive reliable and growing dividends. However, there are no derived benefits from owning gold equivalent to dividends and the only way you will make money is if someone else agrees to pay you more at the time you wish to sell.
Gold has a history as a store of value dating back to China 3,000 years ago and to Great Britain in 1377 when it shifted to a gold standard - whereby paper money is the medium of exchange but is also readily convertible into gold. However, this is no longer the case. The U.S. originally adopted the gold standard in 1900 but by the 1970s gold was allowed to float freely and the gold standard was effectively abandoned, as it had been in other countries, leading the way for gold speculation.
On Jan. 18, 1980, gold reached a new closing high price of $835 per troy ounce on the London Bullion Market. Subsequently, the price declined to a low of $252.90 an ounce on June 21, 1999, before starting its assent over the past decade where it has recently hit new highs of close to $1,200. However, adjusted for inflation, the 1980 record still holds, which is equivalent to over $2,300 today.
Gold investment returns are extremely sensitive to start and end dates. History shows that the worst time to invest in gold, even with a long 10- or 20-year horizon, was in the early 1980s, when stories abounded of line-ups for such purchases. At that time, the U.S. dollar was weakening against foreign currencies, there was fear of inflation, there was economic uncertainty, there was a weak stock market, and there was considerable political uncertainty, particularly in the hot spot of Iran. Today it's déjà vu all over again.
A bet on gold is often a bet against economic prosperity. Consider investments in gold versus U.S. stocks in each of the past four decades. The average annual return on a gold bullion investment in the 1970s, when gold prices began to float freely, was a whopping 31 per cent compared to an investment in S&P 500 stocks, including dividends, of around 6 per cent. Yet for each of the next two decades, gold prices dropped at an average annual rate of around 3 per cent while stocks were returning about 17 per cent. It was not until the most recent decade - since 2000 - that gold has taken the lead with annual gains of around 14 per cent compared to a slight loss for stocks. It's a decade that began with the deflating of the tech bubble and now is drawing to a close as the recent U.S. housing bubble and credit crisis is finally fading.
"Going for the gold" now may be a strong bet against any prospect for recovery in the U.S. for the next decade or more, as well as a bet in favour of the emergence of new and greedy gold bugs enticed by recent record prices, bets I'm not personally willing to take. As it pertains to gold, now might be the time to heed the sage advice of Warren Buffett: "Be fearful when others are greedy, and be greedy when others are fearful."
