Whether Gold Is An Irrational Investment

by: Christopher O'Leary

Gold has delivered remarkable investment returns, from 2001 to 2011 it has increased fivefold, analyst are now predicting that the shiny metal will hit $2000 an ounce by next year. It has come to astonish me that this worthless lump of metal whose value is "in the eyes of the beholder" is becoming a staple for every investor’s portfolios. John Maynard Keynes referred to gold as the "barbarous relic," I agree, it has become an asset class bought on the assumption that there is a "greater fool" willing to pay a higher price for it.

Nearly every day you’ll see a financial professional or journalist extolling the virtues of gold. The reasons for investing in this precious metal are well established, the five justifications typically repeated are usually:

  • It is a protection against inflation.
  • It is a hedge against currency devaluations.
  • A safe haven in times financial market instability and deep uncertainty.
  • A vital way to diversify ones portfolio.
  • The fundamentals of demand and supply support higher prices.

Whilst some of these don’t stand up to scrutiny, most are legitimate reasons, but is it rational for investors to pile into a mainly worthless metal when they could be channeling their scare capital into businesses that create wealth? The euphoria for this asset class is reminiscent of the dotcom and property bubbles. Even George Soros, one of the greatest hedge fund managers in the world referred to gold as the “ultimate bubble,” he says “it is certainly not safe and will not last forever.”

I believe gold is caught up in a gigantic bubble, one that is similar to the south sea bubble and the tulip mania. Its chief driver is financial and technological innovation, gold was previously only traded through dealers and street shops, now it is traded predominantly through exchange traded funds over the internet. ETFs which are derivatives that give retail investors easy exposure to gold is a significant financial innovation and the major difference between this gold bubble and previous ones. According to the World Gold Council (WGC), investment demand (ETF’s plus bars and coins) accounted for 35% of total demand in 2010; this is compared with less 10% in 2001. At the same time jewelry demand has continually declined, falling 18% from 2004 according to the WGC, this now makes ‘investment demand’ which is driven by collective investment vehicles like ETFs one of the biggest driver of gold prices. Suki Cooper of Barclays Capital says flow data indicates that “ETFs are now being traded more dynamically by investors than an original buy-and-hold” approach; this again highlights the growing speculative interest in gold and further evidence of a commodity becoming detached from the fundamentals. The growing influence of financial tools like ETFs will inevitably lead to a market driven by sentiment and speculation. It is ironic to note that despite gold hitting record highs, gold mining stocks have continued to underperform. Tye Burt, Chief executive of Kinross Gold has despondently admitted that investor’s preference for using ETFs to gain exposure to gold has “somewhat cannibalised the demand for mining equities,” this party explains why mining stocks have failed to deliver the stellar returns of gold ETFs.

I believe the main drivers of the gold bubble have been the internet, the media and financial innovation. The marketing of gold to the masses, whether it is commentators appearing on Bloomberg to advertisements encouraging you to trade your jewelry for money are becoming the first ominous signs of a bubble. If gold is such a sound investment as many professionals would make you believe, why does it need to be backed by gigantic advertising budgets to keep investors interested? Alan Greenspan, the former chairman for the Federal Reserve coined the phrase “irrational exuberance” during the Dotcom bubble, the same description can be applied to gold at present. The fund manager of Artemis Income, Adrian Frost summed up his thoughts on gold by eloquently saying “Gold is a club of collective terror where the people who hold it spread doom and gloom – and then invite you to buy the store of value that they own at a higher price than they have paid. It is an elaborate and enduring spoof, but one that has infinitely attractive characteristics.” Gold is slowly becoming another asset class driven primarily by speculation and herd mentality.

You might think that my argument leads me to recommend that you avoid investing in gold; however the factors underpinning this bubble remain firmly in place. Negative interest rates, growing anxiety over sovereign debt in Europe, concerns over inflation, wildcards of geopolitical instability and financial innovation will continue to support higher gold prices. Gold is an irrational investment, but as a bet on the herd I would favour gold as I expect other fools to pile in at a higher price. This is a high risk but profitable strategy for the adventurous investors, it requires bravery, luck and skill to get in and out before the bubble burst. Following the Annual conference of the CFA Institute, John Authers, head of Lex column at the FT wrote in an article titled “In times of trouble, go with the money flow” that investors could hedge themselves against heavy volatility and concern over the health sovereign debt by investing in gold. His justification is that there is “great comfort that the great weight of the world’s smart money will be making just the same bet.” He concluded that “In times of trouble, follow the money.”

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.