Gold And Principles Of Investing 101

Includes: GDX, GLD
by: Cagdas Ozgenc

For the last six months gold investors lost a lot of purchasing power, quite contrary to their beliefs that gold actually preserves it. The last two days were a disaster. This will be a long article, but bear with me. I will try to cover a lot of related, but at the same time not touched issues in mainstream media. One key principle of investing is to know how to make correct decisions under uncertainty and limited resources.

Everything starts with the very basic concept of Expected Value (EV), the average of all possible outcomes of an event. When you are placing a bet you should ask yourself: is the average of outcomes in my favor? In a casino all bets are against your favor, so in the long run you cannot make money. Nevertheless since one bet can be placed only once (you can repeat the same bet, but here I am talking about a bet in a point in time), you will not experience the average outcome. This is due to volatility. Volatility is a measure of dispersion, a measure of uncertainty, from the average value. This is also one of the major observational biases people have: unable to observe the expected value.

You hear people say: "When winning, take the money and leave the casino." This is complete rubbish. It is irrelevant whether you collect your winnings or not if you are planning to come to the casino tomorrow again. You just had volatility in your favor, in other words you were lucky so far, but eventually long run behavior takes over if you keep playing today or tomorrow. If you have the possibility you can simulate the effect of expected value by placing the exact same bet, under exact conditions, infinitely many times, in the long run it will converge to the expected value (there are other technicalities but I will not get into those here).

Having defined the basic terms, what is decision making under uncertainty? When there are two bets you can place, both having equal average outcomes (expected value), which bet is better? If we had infinite trials and infinite resources it wouldn't matter. However it matters when you are going to play the game finitely many times (as we all mortal beings do), and more importantly when you don't have infinite capital. Rational investing suggests that you should choose the one with the least volatility, because it reduces the uncertainty of the result. When you make a bet that goes bad it reduces your capital. If you have a long streak of bad luck (even if the odds are in your favor this can happen) you can eventually lose all your money and can't play anymore. You are out of the game.

Now I would like to propose a thought experiment. I asked this question to many people and most of the time got a wrong answer. When two people play a fair coin toss game repeatedly by placing equal amount of bets each time, where the winner collects the wagers, who wins in the long run?

The correct answer is not a draw. The person with deeper pockets is more likely to win. If you play long enough both players will time to time experience long losing streaks. The one with the smaller capital is more likely to be kicked out of the game before the other one. The game ends with the guy with deeper pockets winning all the money of the small investor.

Small investor -- yes, that's you. People have been talking about market manipulation since inception of the financial markets. I will now tell you how big daddies get your money according the concepts that I earlier described. Let's say you bought some gold after calculating that the odds are in your favor. Big daddies start selling paper gold and depress the gold price until the price drops to those levels that your stomach cannot further take it or you are pissing your pants that you won't be able to pay back the loan you took to invest. You panic and sell your gold as well contributing to further price drop. Then daddies start buying back making money from the price drop you caused. Since small investors also frequently invest by loaning, called margin investing, pressure intensifies when the broker knocks on your door for a margin call. If you think this only happens in financial markets you are wrong. When you are in financial trouble sharks will always be there. They will foreclose your home for nothing then sell it for a reasonable price. It is called taking advantage of a distressed person. That's how rich get richer.

However, if you had deeper pockets than the other daddies you could bust them. Remember the movie "Indecent Proposal"? Robert Redford, a rich guy, places a huge bet in a casino to impress a girl and wins, busting the casino even when odds were against him on the average. It is a good time to repeat here that Expected Value applies to infinite trials and infinite resources. I am sure some time in your life one of your friends approached you thinking that he found a genius way to make money in roulette in casino. The logic goes as follows: You place your money on black (pays 1 to 1 with the exception of ball landing on green color zero which makes slight negative average outcome for you), say $10. If you lose you double your bet, if you win you go back to the initial wager. After a long losing streak if you win you recoup all your losses and win $10 on top. With this method you plan to get rich. The reason this approach doesn't work is the same as that I explained above. You will go broke before the casino. Moreover casinos put a maximum wager limit in order to eliminate the risk that somebody gets very lucky and busts the casino making the scheme practically not applicable.

So how can you defend yourself? You should understand that the game is not in your favor. Normally a small investor should refrain from playing this game, but there is nowhere to hide really, you are always in the game with even a savings account in a bank or cash under your pillow. However, the small investor also has some advantages. The biggest advantage is ability to place bets without moving the market drastically. It is much easier to place $100 thousand dollars in stocks than placing $100 million, which will move the stock price outright for most of the stocks.

The first line of defense is to set your stop loss and realize gain points. The worst thing you can do is to double down when you are losing. This mathematically increases your risk of ruin. Risk of ruin means losing your capital, hence not be able to play in the game further. You will hear from uninformed goldbugs that when the price of gold goes down it is an opportunity to buy more. No, no, no, no, and 500 times more no. This is complete idiocy. Under limited resources it doesn't work. You cannot put your money on black on roulette and double down when you lose. The casino will bust you even when you have positive EV.

The second line of defense is to lower your volatility. Yes, big daddies will push the market back and forth but they cannot do it for all instruments at the same time. You diversify, and you don't leverage yourself to an extent that you are kicked out of the game. Survival is crucial. One way to lower volatility is to use financial instruments that have interim cash flows. Gold is the worst option, because there are no interim cash flows and the only way you can make money is price appreciation. This makes it a very easy target for big daddies.

What's the deal with the interim cash flows? Every instrument has a fair value. Fair value is the present value of all cash flows instrument will generate until infinity. If the current price is less than the fair value you should buy the instrument, if current price is more than the fair value you should short-sell the instrument. This way you make sure that your bet has positive EV. If you are buying an instrument where current price is above fair value, you are already making a sucker's bet. But as I said before many people get fooled by volatility. Sometimes you leave a casino winning, because you were lucky that day. In the long run this strategy will cost you a lot of money. As a side note here, I would like to emphasize that at the moment nobody knows what the fair value of gold is. This presents additional challenge for gold investors. I am bullish for gold, but that means nothing when I don't know what the fair value of gold is and unable to compare it to the current price.

Even if you place the right bets, there is still the same problem. Again, we are mortal beings -- we don't live for eternity. You should have a predefined investment horizon according to your plans in life. You will need the money at some point in the future. Cash flows beyond that point is not really relevant to you. You cannot have hold to grave investment horizon like goldbugs. It is futile. When you have hold to grave investment horizon it is irrelevant what you hold.

Now another thought experiment. Think about a company who is well managed, makes great returns and growing, but never pays dividends. Theoretically stock price should move higher. But that's just theory. Who knows what will happen to the price when so many players are involved. Apple stock is a good example. What dividend does is that it keeps Mr. Market in check. It helps big daddies fight with each other rather than conspire against you. If one of them tries to suppress the price the other one will immediately see it as an opportunity to buy because yield (quite analog to EV) is much more observable now. He makes a very simple calculation. He knows the current price, he knows the expected dividend, he knows the exact time he will get paid. He considers other options and sees that price is steal and buys. Interim cash flows will push an instrument toward its fair value by bringing all those uncertain cash flows far from now to a closer time distance.

Gold doesn't enjoy any of these advantages. We don't know fair value. We can't calculate yield. No interim cash flows. Very little consumption demand to carry out even a simple supply demand analysis. But the most important question is, why gold? Why not any other durable, storable totem?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.