If you have read my previous articles on gold, you already know my opinion (it is just another commodity with an interesting history). The myth of gold as an inflation hedge comes from a rather primitive observation, when the value of money decreases, the value of gold rises. The myth goes like this: if you bought 100 ounces of gold at the yearly average for 1969, you spent $4109, if you sold it today, you would have $79,400. That’s a gain of 1832%, or 48%, a year.
On the other hand, if you spent the same amount on the Dow Jones you had bought 4.7 shares of the Dow at the yearly average for 1969. Those 4.7 share would now be worth $73.825 (reinvesting dividends). A gain of just 1700%, or 45% , a year.
Gold sounds like a an excellent investment, right?
Wrong. And here is why.
First, the $79,400 you have now, are enough to buy… 100 ounces of gold. Basically you sold dollars to buy some gold and then sold the gold to buy some dollars. There is no loss, but neither any gain. The problem however, is that to make any money you would need to trade the gold. Holding anything without the intention to sell is not a strategy of any sorts. At some point you will need to somehow realize your investment. Otherwise is just a paper gain and just illusory.
And here comes the problem, because if you had sold your gold in 2005, you would have made $44,474, while you would have made $49,486.9 on your Dow Jones investment, without reinvesting dividends.
This chart shows, as positive values, when the Dow Jones was a better investment than gold, and, as negative values, the opposite.
As you can see, in some circumstances, the Dow proved to be a better investment than gold, and, at some other times, the opposite was true. The bottom line is, gold is not a particularly better hedge than other forms of investment if you don’t consider the timing of the transactions.
Do I think gold is a bad investment in general? No! I think it is a great instrument for speculation, but, when you compare its yield year by year, you will notice that you can make or lose money, it is not a safe bet by any account. As you can see in the following chart, gold would have made you money only if you bought in 1971 and sold in 1974, or bought in 1976 and sold in 1980, etc. But the longest run you may have had would have been of 4 years, and that’s if you timed the market perfectly.
Now that we have proven that gold is not a superior investment if we don’t time the market, let’s see how it fares against inflation. To do this I will invite you to a thought experiment. Let’s imagine a type of good that in 1969 had the cost of 100 ounces of gold. Our good has some other characteristics as well, its price does not change based on supply and demand. This commodity is the most boring commodity on earth to trade, and consequently its name is Borodium. Borodium only changes in price based on inflation data and is the ultimate hedge against inflation. Borodium places an interesting problem though, how do we measure inflation? You see, if you calculate inflation with the Consumer Price Index, you will have different numbers than if you use 10 year notes, or 1 year notes. But that’s another story. No matter how you measure inflation, gold proves not to be a hedge against inflation.
The Borodium adjusted with the Consumer Price Index will be called Official Borodium, and this is its chart.
Now you can see why they call it Borodium, its price rises permanently and only adjusts for inflation. The value of 100 ounces of Borodium in 1969, as we said, was $4,109 or 100 ounces of gold.
For gold to be a hedge against inflation, the chart should be an ever rising slope, like Borodium’s. And yet, it is not, as you can see in the following charts.
The claim of gold as a hedge against inflation is based on the fact that the value of 100 ounces of Borodium today is $23,461.49, and with our gold investment at $68,755.00, we made a nice profit, and we now have 250 ounces of gold.
However, if we had bought our gold in 1974, at any time between 1979 and 1984, or at any time between 1986 and 1989, our gold investment would have lost money against inflation, the opposite of a hedge against inflation.
Again, how much of a hedge against inflation, and and how valuable as investment it is depends on timing the markets. For instance, had you bought gold in the peak of 1980 at 7 Borodium, you would have lost 80% of your money from High to Bottom, and as of today you would have lost 58% of your money.
That should be enough to dispel once and for all the myth of gold as a hedge against inflation. But I will keep on going because I am on a roll.
Now, we will see other ways in which Borodium is priced in the market. For instance, Borodium adjusts its price based on another inflation indicator by proxy, like the US Treasuries. We will use the 1 year and 10 year treasuries data because it is readily available.
As you can see, gold, when compared to the yield of 1 year Treasury notes (risk 0), is not a consistent investment and behaves as many other speculative instruments.
Compared to 10-year treasury notes, it is even a worse investment.
How bad? Let’s say that for gold to act as a hedge you would have had to buy in 1960 to see a return of 16% after 38 years, or at the bottom of 2001 to see a return of 110% today. Which is about the same you would have made buying the low of the Dow Jones in 2001 and selling the top this year.
This article is part of the series "Documenting The Hyperinflationary Genesis"
- Bernanke’s creative solution: Let’s do it again
- At a financial crossroads
- How to survive hyperinflation
- Let the party begin. We will be dead tomorrow
- I have $ 100,000,000,000 and yet I can’t retire
- Is the Dow Jones at a new high?
- Stagflation: This Time It Is Different
- The Myth Of Gold as Inflation Hedge
- Is Gold a Hedge Against Excess Liquidity?
- Disposable Personal Income Shows Disturbing Historical Trend
- Things That Go Bump in the Night
- Greenspan: Give Homeowners Financial Aid: Financial News – Yahoo! Finance
- Black Swans, Bell Curves and Stagflation
- The Gold Scam
- And Now They Tell US
- Some Historical Perspective on the Current Recession
- Gold Correction Seems Over
- Gold Chatter
Franklin @ December 2, 2007