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Fool’s Gold

Fool’s Gold

Gold continues its meteoric rise and currently sits at multi-year highs.

Content-thirsty Big Media has flooded the airwaves and newspapers with more and more stories about the surge in gold prices and speculation about the cause(s). Now retail investors are taking notice and starting to ask whether now is a “good” time to buy gold. Let’s dissect the arguments…

As with most asset classes, gold serves a necessary function within investors’ portfolios. It’s a wonderful diversifier due to its low correlation with financial assets such as stocks and bonds.

Gold has historically been an effective hedge against inflation. If you believe in The Fed’s hawkish campaign, you’ve got your explanation for gold’s price surge.

Gold has historically been a play on currencies. The US Dollar goes up and gold falls. The Dollar declines and gold spikes. One need look no further than what has happened to the Dollar over the past 3 years for an explanation of gold’s rise.

On the con side of the equation, the concept of useful life does not apply. Gold supply never shrinks. There’s no such thing as spoilage or depreciation. In fact, gold supply only grows due to mining operations and central bank liquidations.

Gold does not produce earnings. We can project earnings from a product into the future and discount them back in order to calculate a present value or fair price. We can’t do that with gold.

As a result, gold has been commoditized. It’s become less of a valuable keepsake and more of an industrial raw material.

So what’s an investor to do? The smart money takes into account gold’s pros and cons. Coupled with its historical price volatility, gold enters and exits portfolios in a moderate, averaging fashion.

Retail investors, however, have a nasty habit of buying high and selling low. Need proof? Let’s look at an example…

Until the recent advent of the gold ETF, the closest proxy for gold was a mutual fund investing in the stocks of mining companies. While not a pure gold play, it was the closest retail investors could come to owning the metal.

One of the top performing funds in the category is American Century Global Gold – a fund earning the coveted “Analyst Pick” from independent mutual fund authority Morningstar. The following data is provided by Morningstar and is accurate as of 8/31/05:

(Editor’s Note: American Century Global Gold is used for illustrative purposes. Apollo Wealth Management, Ltd. is not expressing an opinion as to the quality of the fund, its appropriateness for investors and is not offering a “buy” or “sell” recommendation).

(as of 8/31/05)

Rate of Return Growth of $10,000
3 months 12.35% $11,235
6 months -3.86% $9,614
1 year 3.80% $10,380
3 years 13.88% $14,769
5 years 23.23% $28,417
10 years 0.72% $10,744

 

What can we learn from this data? Because the price of gold is highly volatile, the timing of buy and sell decisions is critical. Investors have a lousy track record of calling “tops” and “bottoms”. Efficient market theory suggests it’s a losing bet.

An investor who bought this fund within the last 3 months earned over $1,200. Buying 3 months earlier would have resulted in a loss of close to $400. What a 3 month swing!

An investor who bought this fund 1 year ago is essentially breakeven.

An investor who bought this fund 3 years ago earned close to $5,000.

An investor who bought this fund 5 years ago earned over $18,000.

Not bad!

But what about the investor who bought 10 years ago? We’re told to buy and hold, right? Buying and holding this fund meant a 10 year rate of return close to 0%. Yes, 0%!

When all is said and done, the price of gold is much too volatile and subject to too many factors to be encapsulated into a simple “is now a good time to buy?” question.

Caveat emptor!

(Editor’s Digression: Aristotle and his “A is A” axiom must be rolling in his grave each time an investor asks if it’s a “good” time to buy!)

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