Why Gold Could Be the Safest Investment Out There

 |  Includes: GDX, GDXJ, GLD, IAU, PHYS
by: Gold in Mind

A look at the past 177 years of the gold price reveals that unexpected write-offs are non-events—gold could be the safest investment out there.

Investing into anything is usually preceded by the thought: what is there to win and what is there to lose? There has been a lot of discussion about the upsides of the gold rally. But little if nothing has been said about the potential losses. Clearly, many people are wary of investing in gold because they fear that the gold price could suddenly crash.

Gold has so far attracted only $5.4 billion worth of private investment in 2010. At the same time, investors poured $22 billion into emerging market mutual funds and $155 billion into bonds. While some commentators have labeled gold a bubble, these numbers show the exact opposite. Being a tiny fraction of the bond market's value, gold remains a niche investment. The fear of the unknown holds savers away from gold, and the media hype is not helping.

Most people perceive gold as speculative, whereas cash (CDs), bonds, real estate and managed investment plans are considered to be safe, conservative investments. But how likely is a sudden crash of the gold price? If history is any guide, it's not likely at all. In fact, gold has less surprises for you than any of the assets mentioned above. If you are a conservative investor, you must have a closer look at gold.

1833-1969: Virtually no setbacks

The dollar-gold exchange rate was set to $18.93 per ounce in 1833. Between 1833 and 1970, there was virtually not a single notable year-on-year drop, with the exception of 1931. That year the gold price fell from $20.65 to $17.06, a minus of 17%. But considering that in 1931 and 1932 the general price level also dropped about 10% each of these two years (while the gold price was set back to $20.65 in 1932), gold practically didn't lose any real purchasing power but actually gained some during the deflationary Great Depression.

The situation has changed since the late 1960s and early 1970s when the free gold market started to form. In 1971 the U.S. effectively abandoned the gold standard and no longer guaranteed the fixed exchange rate of $35 per ounce. With gold now being traded freely around the world, the gold price became more volatile. Has gold since become a risky investment?

1970-2010: Losses are minimal compared to gains

Even in the post-gold-standard years, gold has never surprised with a sudden crash. With one exception. In January 1980, the Soviets invaded Afghanistan. The world was already shaken by the 1979 oil crisis and the Iranian Revolution that was drastically changing the balance of power in the Middle East. This geopolitical earthquake made the gold price skyrocket from $559 to $843, only to fall back to $668, all within the one month of January in 1980. However, it is probably safe to say that this was a very short window of opportunity and virtually no private investors managed to buy gold at the peak that lasted only 2 days.

In order to study how much a typical leisure investor could lose by investing in gold, let's consider somebody who invests very infrequently, say once a year. Let's say our person reserves the first workday of May for this activity. So if he decides to buy or sell gold, he'll have to do it on this one day of the year. For this imaginary person, I computed gains and losses for every year since 1970 by comparing the gold prices of the first trading day of May. Let's see what came out (I highlighted the top four losses and top four gains): (Click to enlarge)

Click to enlarge

For our investor, the maximum loss suffered in a year in the past 40 years was -29.1% in May 1982. Frankly, I can't think of an investment that offers notably higher safety. Commodities, stocks (mutual funds), cash, real estate — all of these can lose 30% or more within a year easily. Actually, I bet that I could find annual losses of 50% and more in every single one of those markets in the past 40 years. Even if you think of bonds, they can still easily lose 30% or more within a year if the currency they are denominated in drops. The same applies to cash. If your currency loses 30% in international comparison (which is nothing unusual), your imports (which for many people are the main part of their consumption) will soon get more expensive by a similar if not greater margin.

Hence, it seems that gold is one of the most stable investments out there. It just doesn't bust. Even after the supposed "gold bubble" of 1980, there was no bursting. Rather, it was a gradual deflation with enough time to get out. Even our imaginary investor didn't suffer any notable damage and had plenty of time to exit before making a loss.

Two more interesting things can be noticed:

  • Each of the top four significant losses was followed by a year with a gain

  • The maximum losses are generally much smaller than the maximum gains. While the maximum annual loss is around 20%, the top four hikes were all above 50%. In other words, gold combines limited downside with great upside potential

The last point mentioned is not a coincidence. It is the key logic of the gold price: Because the amount of physical gold available for investing is limited, any crisis in the global financial markets usually creates a run on gold and an over-proportionate price spike. But while financial crises set in fast, the recovery is usually slow. A recovery is bad for the gold price, but because it is slow, the deterioration of the gold price is gradual. Stocks and most other markets act in the opposite way. They grow slowly and crash fast. The gold price "grows" fast and "crashes" slowly. This unique inverse property of gold turns it into an inevitable cushion for any investment portfolio.

1980s, 1990s, 2000s ... what's next?

Of course, you may argue that during the 1980s and 1990s gold was a miserable long-term investment. I would agree with that. Gold lost 87% of its purchasing power between 1980 and 2000. But exactly because of the property described above, everybody had enough time to get rid of their gold. There were plenty of signals that gold would not be a good investment in that period—interest rates were high, emerging economies ensured attractive returns from the stock markets and the gold price was being watered by the central bank gold sales. Let's compare the signals from back then with those of today:

Signals 1980s-1990s Signals 2010s

  • Fed's Paul Volcker made it clear that he was serious about fighting inflation, raising the prime rate to as much as 21.5%

  • Fed's Ben Bernanke is not serious about fighting inflation at all, the prime rate is to stay sub 1% and a new round of Quantitative Easing is en route
  • The Soviet Bloc fell apart which created tremendous, long-lasting tailwinds for the stock markets throughout the 1990s; Asia was booming
  • We have no fresh emerging markets to provide expansion and growth
  • The IMF and central banks were selling gold and they were loud about it. The massive sales by the Bank of England finally brought gold to historical lows in 2001
Click to enlarge

The bottom line: the signals of today are the exact opposite of those we were seeing in the 1980s and 1990s and are telling us to buy gold. And I haven't even touched on the topic of our broke governments that can only pay for old debt with printed money, thus diluting the value of cash already in circulation. Cash, CDs and bonds are outright poison at this point. Yet, that's where most of 401k and IRA money is. It's sad, but what can you do. If you care about your retirement, please have a look at gold. Remember the learnings from above. If gold peaks, it will likely deflate slowly. Because it takes a long time to restore sanity.

And those of you who have already been praising gold's current prospects to your friends—why not mention the downside the next time. It is one of the best arguments for gold.

Disclosure: Long gold