All That Glitters May Not Be So Golden

Debate has raged for some time now about the utility of gold in a portfolio.Forget, for a moment, the breathless claims of infomercial touts and Parade magazine advertisers. Think, instead, of asset class selection.

Why should anyone add gold—or, for that matter, any asset—to a portfolio? The answer that comes immediately to many people's minds is "return." It's the promise of outsized, and often outlandish, returns that entices people to call that 800 number in the wee hours of the morning to get their hands on the yellow metal.

There's no doubt about gold's current price jag. Gold for spot delivery is now $786 per ounce, a five-year high. Back in the market-bottoming days of 2002, you could have picked up the metal for as little as $308. Gold has risen more than 152 percent in the past five years, producing a compound annual return of about 20 percent.

Not bad. Especially when you consider the contemporaneous return for stocks, as measured by the S&P 500 Index, has been only 12 percent per year. Are these guys with the mile-a-minute pitch really on to something?

Well, that depends upon your views on inertia. We can plainly see the return generated by gold in the past, but what can we expect of gold in the future?

Gold becomes most appealing to investors in times of uncertainty. In the late '70s, inflation ran rampant, oil prices spiked and currencies spiraled downward. Gold, just unfettered, sought its level, eventually peaking at $850. We're again in uncertain times. Stock market wobbles, a weakened dollar, soaring fuel prices and jawboning about inflation have all contributed, according to some analysts, to gold's recent appreciation - better than 30 percent in the past 12 months alone.

Gold isn't the end-all, be-all, however. In the long term, the metal's price is notoriously unstable. Since gold's price was allowed to float in 1970, its annualized standard deviation—its price variance—has been clocked at nearly 20 percent, versus 15 percent for blue-chip stocks. And in that time, gold's return has only averaged 8 percent. The S&P 500 earned 11 percent per year.

So what return can we expect from gold? Well, financial theory says you can't expect any increase in an asset's value without growth prospects. Stocks' expected return derives from earnings growth. Issuers of corporate securities can create things and grow. There's a real prospect for a company trading its shares or warrants to be worth more and more as the result of management decisions. Gold itself doesn't produce earnings, and for that reason its expected return can be approximated as zilch. Nada. Bupkis.

Appreciation in the price of gold, of course, does occur. History attests to that. There's just no reason to expect it. What influences the price of gold are external, not intrinsic, forces.

It's a different story, however, for gold-mining stocks. As corporate entities, mining operations can grow and generate expected returns.

Funds made up of gold-mining stocks are the most commonly employed vehicles used by retail investors to deliver precious metals into their portfolios. Gold-mining funds tend to be some of the most volatile of assets, often registering huge gains and losses in rapid succession. Gold-mining fund prices can, in fact, be twice as volatile as the price of the underlying metal.

Compare, for example, the recent performance of streetTRACKS Gold Shares (GLD) with the Market Vectors Gold Miners (GDX):

Standard Deviation 12-Month Return Gold ETF (GLD) 15.7% 32.2% Gold Miners ETF (GDX) 29.8% 29.6%

The reason for the mining stock fund's greater volatility? Mining stocks magnify gold's moves because of the enormous influence the metal's market price has on a company's earnings.

With production costs averaging between $269 and $339 per ounce at last look, gold price changes go straight to a producer's bottom line. One company estimates that a $10 uptick in the price of gold—about a 1 percent rise from current levels—translates into a $50 million change in earnings, all other things being equal.

There can be a payback for that higher volatility, however. Gold-mining funds can be more useful as a portfolio diversifier— a counterbalancing force—especially against a fixed-income allocation. The dosage required to achieve efficacy, however, is a lot less than the infomercial touts would have us believe.

Comments

[Greg Pinelli:]

Gold and silvers volatility are precisely why they are excellent speculations. To understand gold's value to a portfolio its critical to appreciate what gold really does..and that is only one thing...currency protection. Gold provides virtually the ONLY easily accessible, universally recognized and accepted counterweight to currency depreciation.
How committed are governments and Central banks to protecting the integrity of their currencies? If your equities are paying dividends of 5% per annum and REAL inflation is 6% how much have you REALLY earned?
I have no idea whether gold will go up or down in the next 6 months...like every other investment that is up to the markets. I do know, however, that there is virtually NO committment to currency integrity in any country of note and gold (and to some extent silver) are almost the only physical assets I can hold that will adjust accordingly.
Also...there are shills for EVERY investment..including packaged sub prime mortages..ever heard of Citicorp??

2007 Oct 30 11:12 AM

[Mark of Texas:]

I agree Gold doesn't make money, lately I think it is only going up because our dollar is wasting away but stocks and bonds and the stock market are also not doing that great at this time. The value in Gold will not I repeat will not go away if the stock market, Bonds, or the good old US Dollar drop out of value, I include if these funds drop to almost no value to the rest of the world Gold will still have value and silver, copper, and the other metals will always be needed for any kind of growth in the world. The history of the world not just the last 200 years shows us that Gold will always have value even when world paper currency is of no value. A safe haven it is now and always will be but dont look for growth if our dollar keeps tanking Gold will continue to rise. Sorry to inform you but I dont see a reblooming of people looking to buy USD$.

2007 Nov 01 12:57 AM