brewtul

Gold as an Investment? Think Again

One more comment about the value of the Dow versus gold, inflation adjusted or otherwise. The Dow is not a group of 30 stocks, it is a managed fund. That means there is a huge survivorship bias built in. Stocks that do poorly simply drop out of the Dow when it is rebalanced periodically. If you had "bought the Dow" in 1900 you would have seen most of the 30 companies you bought eventually go bankrupt. So let's say that you really do not "buy and hold the Dow" but rather buy and sell every year as necessary to have your holdings mirror the Dow. Then transaction fees start to add up materially affecting your returns.

Another problem with the methodology has to do the way average percentage yields are calculated. To walk through an example. Let's say that at the start of 2000 the Dow is trading at 10,000. In 2001 it closes unchanged at 10,000. Let's then say in 2002 it falls badly to 8,000, a 20% loss. Let's say finally that in 2003 it rebounds strongly to 12,000. Now think about the investor who bought in 2000. After 2 years he is looking at a loss of 2000 points, from 10,000 to 8,000. He is down 20% over 2 years. The average annual percentage loss is then simply the square root of -20% or about -9.5% per year. Now let's look at his more fortunate counterpart who bought the Dow not in 2000 but at 10,000 in 2001. Two years late in 2003 the dow is trading at 12,000 and he is up 20%. Annualized this is 9.5% per year gain. See where this is headed? Although we have all heard the Ibbotson study that says stocks return ON AVERAGE 7.2%/year only a few have pointed out the flawed methodology. IT makes a huge difference what year you start counting in. The way to fix this problem is create several model portfolios each starting in a different year and then continuing for say 50 years and then AVERAGING the returns. It so happens that Ibbotson started his study in 1900 the start of a long bull market. Had he started his study in 1929 that 7.2/year return would have dropped dramatically (I think the number may have been closer to 4%).

Gold as an Investment? Think Again

The argument is an old one. Keynes called gold "a barbarous relic" in 1923. The implication is that modern finance has created a more efficient, higher yielding, paper system that has made gold based economies obsolete. The problem is despite whatever financial innovations paper economies engender those economies all eventually end in ruin. Men are intrinsicaly selfish and greedy and giving a small group of them power over the creation of currency always leads to debasement and final collapse. Such events are historical in time frame and 30 year windows chosen selectively to make the counter argument do not prove otherwise.

The author is correct that gold is not an investment, but rather a sort of insurance policy. Insurance against what, though? Insurance against debasement is the answer and since the bursting of the tech bubble we have seen debasement accelerate at an alarming rate. This is why people are buying gold - not because of visions of armageddon. And so far they have been right. Were it not for generously massaged financial stastics coming from the government there would probably be a lot more flight to gold as people would realize that inflation is probalby running close to 10%.

Think of it this way; Say you are a retired little old lady with $1,000,000 in the bank earning 5% a year, netting you $50,000 (pretax, of course) to live on. If inflation is running at 5% a year that is the equivalent of 100% tax on your earnings. If inflation is running at 10% a year that is 100% tax plus another 100% in penalties for having the audicity to save rather than consume.

Don't be fooled by nominal stock market returns. If you bought the Dow on Jan 1 2000 it would have to be 14,184.39 today just for you to have broken even in real terms. And that is using the "official" government CPI with all of its "adjustments". If inflation was calculated using the pre 1980 methodology that number would be closer to 20,000. Still think the stock market is a great deal? How long do you think it will be before the REAL returns on the Dow get you back to the levels of 2000?