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The defining aspect of the information age is our relatively unprecedented access to … well, information. Unfortunately, information comes in two varieties: information and misinformation. Investing has always been the modern day version of alchemy (a "science" from medieval times which really just amount to a bunch of guys trying hard to transmute different things into gold), but some investment professionals (which I define as journalists, economists, fund managers, analysts, etc) seem to think that this unprecedented level of information has turned investing into an actual science.

Or, if you'll pardon a mixing of metaphors, investing is like reading tea leaves: more leaves don't necessarily make your prediction any more accurate. It will always come down to the ability to read tea leaves, the problem for investors is there are so many tea leaves and so many supposed tea leaf psychics out there that it's becoming impossible to tell the information from the misinformation. In fact, the more something gets repeated, the more likely it is to be accepted as fact:

Silk, silk, silk. What do cows drink?

Some percentage of you correctly said "water", while the rest of you said "milk". While that example may be stupid, it is no stupider than these 3 things that you probably believe because you've heard them repeated by various investment professionals. Here are the 3 things that (most) investment professionals just don't understand:

Investment professionals just don't understand …

#3 that gold is not all that rare

If you've turned on any financial news channel or at any point over the past 5 to 10 years you will have heard either the commentators talk about gold (NYSEARCA:GLD) or seen some infomercial trying to get you to buy gold coins. While gold is the most malleable, ductile, long-lasting, shiny, and whatever else of all metals at the end of the day most of the pro-gold argument comes down to one fact: gold is rare.

The rarity of gold is its prime selling feature and you have no doubt heard things like:

"All the gold ever mined could fit into one football field!"

or

"You can't just print gold like you can fiat currencies like the U.S. dollar!"

While both of those statements are true, they are both misleading as they intentionally (in my opinion) ignore the fact that current gold prices already more than factor these things in. The first statement really doesn't mean much. How large does the world gold stockpile need to be in order for gold to no longer be considered rare? 5 football fields? 500? The point is its largely arbitrary and irrelevant statement of size. So maybe it would be best to relate it to the second statement. How many football fields of U.S. CASH are there?

First, let's examine the statement of all the gold ever mined. We don't know exactly what that figure is, but Google tells me that somewhere in the neighbourhood of 160,000 tonnes is a reasonably conservative estimate. Again, according to Google, the density of gold is 19.3 tonnes per cubic meter. So we'd need 8,290 cubic meters of gold to get to 160,000 tonnes. Once more Google tells me that a football field is 360 feet (109.7m) x 160 feet (48.8m, including the end zones). That's 5,353.6 square meters, so we know that the stack of gold on one football field will be about 1.55m high (5.08 feet). We also know that around 2,400 tonnes of gold is mined annually, so the stack gets higher by .023m per year.

Secondly, let's look at all of the U.S. Cash currently in existence. To start I'm referring just to bills, not including the reserves held at the Fed. According to the Fed there is currently $1.2 trillion in currency in circulation. Google has once again been helpful as someone has already tackled this problem and found that $1 million worth of currency (in $100 bills) is 0.0106 cubic meters. That means all the U.S. money currently in circulation would need 12,683 cubic meters to store (in $100 bill format). That's a stack 2.37m high on our football field. So in a comparison of volume, all the gold mined in history is approximately 53% more rare than all the U.S. money in circulation (in $100 bills).

How about in more important terms … like value? Well we know that the value of our $100 bill football field is worth $1.2 trillion. What's the value of our golden football field? 160,000 tonnes x 32,150 troy ounces per tonne x $1,350 (approximate current price per ounce of gold) = $6.94 trillion dollars. In value terms U.S. dollars are approximately 578% more rare than gold.

I know the response to this will be that I'm not being fair because I'm not including QE and I'm including all the gold mined in history. So let's just look at the last 10 years (2003 to 2012 inclusive) and compare gold production for the period and the change in the U.S. monetary base (i.e. include QE):

Approximately 24,500 tonnes of gold were mined from 2003 to 2012 carrying a value of approximately $1.06 trillion dollars (at $1,350 per ounce). The change in the monetary base during that time (including QE) was approximately $1.9 trillion dollars. If you exclude QE the change in the monetary base was just $0.472 trillion and once you read #2 you will understand why you shouldn't include QE.

So when compared to U.S. dollars (even the creation of new U.S. dollars) gold is nowhere near as rare as you have been led to believe.

#2 QE does not lead to an exponential increase in the money supply

"QE is going to lead to hyperinflation!"

This is by far the most misunderstood thing in finance today. The good news is people with doctorates in economics are getting this wrong too, so don't feel bad. The general view of fractional reserve banking is that some high powered money comes into the system from somewhere (in this case the Fed) and because banks are only required to keep a specific amount of their deposits in reserve, they are free to lend the rest. In this way the high powered money initially put in multiplies exponentially and massively increases the M2. This could be true, if a) reserve requirements meant anything AND b) reserve requirements were the only restriction on banks. Unfortunately, neither A nor B are true, so the entire concept that increasing the monetary base can exponentially increase M2 is flawed.

In the late 80s and early 90s reserve requirements for time and savings deposits were removed. This meant that banks no longer had to hold any reserves against savings accounts, just checking accounts. Since most money in held in savings accounts this effectively reduced the reserve requirement to 1% (10% or so of money is in chequing accounts) of total deposits. Reserves ceased being a concern at this time as the amount of leverage a bank would need to take on in order to hit that reserve requirement would be so massive that even the guys at Lehman Brothers would think it excessive.

The real restriction on lending comes from total assets to capital and the various ratios that banks need to maintain. While capital requirements are getting stricter (slowly; see Basel III), it was still strict enough that the 1% reserve requirement was not an issue for any bank in the 90s and 00s.

So in today's world of banking how could we get exponential growth in M2? Banks would need to be much better capitalized (through either injections of Tier 1 capital or retained earnings) such that they had ridiculous amounts of ability to lend. That's it. QE helped the banks become better capitalized by raising asset prices and reducing the risk they faced (by buying assets from them, especially when there may have not been other purchasers of the assets) but not by a material enough extent that hyper- inflation was ever a legitimate concern. For the most part all the excess reserves created by the Fed's various programs over the past few years will remain as excess reserves until the Fed stops QE. Then the natural expiration of the bonds that they hold will shrink those excess reserves.

#1 that Newton's 3rd law applies to everything

"The market is over (under) invested in equities right now."

We've all heard comments like that before, but it's actually (mostly) a logical paradox. Assets can be overvalued but not overinvested. Newton's third law of motion states that for every action there must be an equal and opposite reaction. In financial terms it's pretty simple: for every buyer there is a seller. It really isn't much more complicated than that, but somehow I rarely see this talked about or understood by financial professionals. The only important thing you need to understand about Newton's 3rd law, as it applies to finance, is that in aggregate there is no way* to remove (or add) money from an asset class and therefore no way for the market to be over (or under) invested in something.

Wait … what? Actually there is a reason that no way above has an asterisk. In the case of stocks you could argue that money flows out of stocks in the form of buybacks (reducing share count by buying from corporate coffers), dividends (receiving payments from corporate coffers), and money flows into stocks when companies issue securities.

Think about it for a second. If you ignore the "special" circumstances above (buybacks, dividends, and new issues) for every share you purchase, someone has sold you a share. For every $100 you invest into a stock, someone sold $100 worth of that same stock. In aggregate more dollars cannot be invested (or divested) from the stock market (or gold or housing) ever. Here's a practical example. Let's pretend ABC IPOs at $10 per share and raises $500mm on their IPO. The $500mm is new cash invested into the stock by investors and is received by ABC (minus fees). Once ABC begins trading the total value of the company may change, but for every $100 invested into ABC someone must have divested $100. If ABC doubles, the value of the company is now $1 billion, but the dollars invested in the company remain $500mm.

So what does that mean really? In times of extreme market stress, like say 2008, there is no way for the market as a whole to reduce their holdings of stocks to repay debt (or satisfy margin calls). This is because there must always be a buyer if someone wants/needs to sell. With the market in freefall (like 2008) buyers are few and far between and the drop in the market generally just necessitates more selling (further margin calls or capital calls at banks). This is why government intervention in 2008 became necessary: there was no equal and opposite buying reaction available. The result would have been sellers forcing the price of all markets to (almost) zero in order to obtain whatever liquidity they could.

While that's terrifying, this phenomenon is actually what makes stocks such a good investment during "normal" times. On a micro basis (i.e. just as an individual) it is easy to get liquidity from the stock market; you can convert stock into cash fairly easily and quickly because you're just a small drop in the liquidity pool. More importantly though, stocks provide a built-in liquidity measure on a macro basis as well. We know that investors rely on stocks to provide cash during times when they need money (retirement, unemployment, vacations, etc). So each quarter there is some (unknown - A) amount of selling demand created by investors, offset by (unknown - B) buying demand (investing bonuses, selling your home, etc), and by cash flow returned to investors by the companies themselves (known - C).

All we know is that the cash demanded from the market (-A-) must equal cash supplied to the market (B+C) and that this argument holds for all different markets (i.e. gold, housing, etc). While it's impossible to know what A+B are, we know that A - B = C, such that the larger the amount of money returned to the market by the investment (again in stocks this would be buybacks + dividends - issuance) the smaller investor buying (-B-) is required to offset investor selling . Generally as well we know that if A - B > C that prices must fall until A - B = C and if A - B < C that prices must rise until A - B = C.

Once again let's look at two markets where the data is readily available: stocks and gold. According to data reported by S&P, over the last 21 quarters the S&P 500 (NYSEARCA:SPY) has averaged dividends of $59 billion per quarter and buybacks of $80 billion per quarter. Bloomberg reports that the entire U.S. equity issuance over the same period averaged (approximately) $50 billion per quarter. This means that, on a quarterly basis, that C = $89 billion for stocks or $1.869 trillion over the period. In other words, selling demand had to be greater than buying demand by $1.869 trillion over the period and as a result prices rose. This is why stocks are good "for the long run", they have a built in way to provide buying to offset selling. If new issuance ever starts to exceed dividends plus buybacks, you can also be sure that it's going to be at least a short term market top (within a few quarters).

Gold, on the other hand faces the opposite issue. Every quarter about 600 tonnes of gold are mined (the equivalent of new issuance in the stock world) and another 400 tonnes of gold is recycled for scrap (again the equivalent of new issuance). Jewelry and technology demand is about 700 tonnes a quarter (let's call this a buyback), so net there is about 300 tonnes of gold that needs to find a home every quarter. This requires net new investment in gold of $13 billion per quarter (300 tonnes = 32, 150 troy ounces x $1,350/ounce price = $13 billion). That means, all else equal, the price of gold will decline every quarter until $13 billion of new money is enticed to invest in gold every quarter. Because of the varying prices of gold over the past 21 quarters, it's not really worth trying to calculate the exact amount that has flowed into gold (again mining is the equivalent of new issuance, which actually does allow for new money flows) during that time. Future prices are more important anyways, and if you wanted the price of gold to remain at $1,350 over the next 21 quarters you will need approximately $273 billion to flow into gold over that time period (or 6 times the current value of the GLD ETF) assuming everything stays the same (in terms of mine production, jewelry demand, etc).

In conclusion, here is one thing that most investment professionals do understand: stocks for the long run … just maybe not gold stocks.

Source: 3 Things (Most) Investors Just Don't Understand