'The Wisdom of Crowds' Helps Explain Gold's Price Climb

All around the world, investors believe in gold.

If you ask them why, you will get a number of explanations and a level of conviction that has endured despite opinions of many “experts” that gold was overpriced at $500, then at $600, and so on until it reached and passed $900.

It reminds me of an enlightening book by James Surowiecki I read a few years ago called “The Wisdom of Crowds.” The book’s basic premise is that “large groups of diverse people are smarter than an elite few.”

Crowd wisdom is not to be confused with “groupthink,” in which members of a group prize consensus and to get it, they suppress any contrary viewpoints to avoid conflict. Groupthink often leads to ill-considered decisions.

Source: streettracksgoldshares.com

The streetTRACKS gold ETF (GLD) chart above shows the amazing growth that the gold ETFs were seeing even before this year’s derivatives and subprime debt disaster that wiped out hedge funds and mortgage brokers, and dealt a harsh blow to the earnings of major banks and brokerages.

The “wise crowd” around the world – institutional and individual investors - has been buying gold as a safe haven from currency risks and the trillions of dollars invested in derivatives, and as a way to recycle petrodollars.

European central bankers selling so much of their gold at low prices is an example of groupthink, as is the media’s reluctance to accept gold as an asset class. When I’m asked to talk about gold on TV, the questions usually come from the perspective that gold has gone up and now it’s time for it to fall.

Back in the 1800s, Charles Mackay wrote a book called “Extraordinary Popular Delusions and the Madness of Crowds,” in which he discusses Europe’s famous tulip frenzy in the 1600s (one bulb sold in Holland for 40 times the country’s average family income) and other irrational market behavior that creates speculative bubbles.

Despite the assertions of some, today’s gold is not the tulip of 400 years ago. While there are many who believe in gold, not everyone is believing and buying. What we’re seeing in the market is not a bubble-blowing frenzy fueled by crowd madness. Below is Kitco’s chart of gold in 1980 – in January of that year, the price went up 40 percent in seven trading days to its peak and over the next five days nearly all of that gain was lost. Now that was a bubble.

Back to “The Wisdom of Crowds,” the following are the four interlocking factors that create the “wise crowd,” as identified by the book. The current activity in gold fits well with these factors.

Diversity of opinion: There are many plausible ways to explain why gold is an attractive investment in the current environment: gold’s positive correlation to the price of oil, its inverse relationship to the dollar, rising wealth and demand in emerging markets, the unknown depth of the escalating derivative crisis, prospects of a U.S. recession, and more. Then there’s the question of whether to buy bullion, gold stocks, gold funds and gold ETFs. With so many variables, investors can believe in gold and still have differences of opinion on the “why” and the “how”.

Independence: Believing in gold does not derive from a fixed formula and it is not a managed process. Investors acting in their own best interests take in what they see as relevant information from a variety of sources and analyze it to arrive at an individual viewpoint that they can act on. This independence minimizes the chances of crowd madness.

Decentralization: One doesn’t have to show up at a designated place to get information about gold or to buy it. Gold believers are scattered around the world, and along with the readily available information in print and online, they can make local observations that add to their knowledge base. Someone in Nevada can note that a local gold mine is hiring more workers, while someone else in Mumbai can see if more people are patronizing the local gold jewelry shops.

Aggregation: Once information is gathered and analyzed by a wide range of self-interested investors located across the continents, global markets present a venue for both believers and non-believers to act. So do local gold-coin shops and jewelers.

These same four factors would also apply in reverse if the “wise crowd” were to decide that gold had lost its luster as an investment. But given the current economic turmoil, I think it could be a while before such a reversal is seen.

Disclosure: One or more of U.S. Global Investors family of funds holds GLD.

Comments

[Rhett]

Crowds are not always wise; they sometimes create bubbles, don't they?