Investors Beware - The Misplaced Infatuation With Gold Could Cost You Dearly

by: Allen Jackson

Gold is a very unique commodity in many ways. As consumers, we wear gold on and around our bodies. We use it as a status symbol and an indication of wealth. Gold has even been incorporated into many monetary systems across the world. Gold serves many useful and vital purposes for society at large. With all these uses, there is one thing that gold is not -- a viable long term investment.

Investors, in recent times, have invested extensively in gold, believing it to be a viable hedge against inflation and uncertainty. In this article, my aim is to present factual evidence why gold is inferior to investing in productive assets over the long term. I will also attempt to dispel many of the common myths surrounding gold and its usage.

To begin, I present a chart highlighting the long-term returns of stocks, bonds, gold and the dollar. Notice how gold has appreciated very little, compared to both stocks and bonds. If an individual invested $1 in gold in 1801, the value of that dollar would have grown to $1.95 200 years later. This equates to a .3 compounded growth rate over the 200-year time period. Assuming a 3% rate of inflation over this time period, the real rate of return from gold over the past 200 years is actually negative. Now, let's study the growth rate of stocks over this period. $1 invested in the market it 1801 would have grown to $755,163 200 years later. This equates to a 7% compounded growth rate over this 200-year period. As an investor, would you rather have a 7% compounding growth rate, or a .3% growth rate? Obviously, a rational investor would elect to receive the 7% growth rate. Remember these two statistics, as they will become important later on.

In essence, the long-term investor is better served by purchasing stocks as oppose to gold in the long run. History has proven this theory correct. Why then, would rational investors want to invest in gold, knowing that returns in stocks are far superior? The answer lies primarily with emotions and speculation.

Gold is a "fear commodity." When investors are fearful or overly pessimistic regarding the future, they tend to flock to both gold and U.S. Treasuries. When investors are fearful about the future monetary policy of governments, they tend to be heavy purchasers of gold. When investors are fearful about the political and economic circumstances of the world, they tend to flock to U.S. Treasuries. Gold is seen as a "safe haven" for investors who believe the future monetary outlook is bleak. However, this "safe haven" is actually one of the riskiest purchases an investor can make. I personally define risk as the probability of losing principle or purchasing power due to an inappropriate purchase of a security. I do not define risk as the beta of a security. Nor do I define risk as the price movement of a particular security over a short-term time horizon. Using the above definition of risk, combined with the insight garnered from the chart, the riskiest assets an investor can purchase are cash and gold. Over the long term, cash and gold are guaranteed to lose the investor money. For one, as seen by the chart, gold will, over time, provide very little value to investors. Why, you may be asking yourself, does gold provide little value to investors?

First, gold is a non-productive asset. If you, an investor, purchase 100 ounces of gold today, 200 years from now, you will still own 100 ounces of gold. No matter how much you shine, buff or coddle it, it will still be 100 ounces of gold. ETFs such as UGL, GGGG, and GLD are all mainly comprised of non-productive assets. Therefore, the only way in which the investor can make money with gold is through the expectation that someone else will pay more for it in the future. As an investor, speculation can cost you dearly. For one, macroeconomic trends, consumer sentiment, and future occurrences are so difficult to predict consistently. I personally, cannot name one individual or economist who has accurately forecast economic trends on a consistent basis. There is simply too much uncertainty in the world to believe anyone can do so with any semblance of consistency. As such, it will be very difficult for the gold investor to make money over the long term by relying on speculation or intuition.

Now, let's contrast the performance of gold with that of a stocks. Stocks, unlike gold, are productive assets. If you purchase 100 shares of stock, most years, the stock will generate earnings for you, the investor. 100 shares of Wells Fargo, for example, can potential generate $3 of earnings or more each year for the investor. This earnings generation is what creates the vast amount of price appreciation of stocks as compared to gold. If you purchase a stock, it theoretically will provide earnings for you year after year. Some of those earnings will be retained in the business to grow and expand its operations. Another portion of those earning will be given to you in the form of dividends and stock buybacks. While gold simply sits and remains unproductive, stocks will continue to generate compounding rates of return for the investor. This is why stocks since 1801 have vastly outperformed gold. Gold, as indicated by the .3% growth rate, cannot compound itself in an adequate fashion. It can only remain stagnant and unproductive in the hopes that someone will pay more for the same amount. Stocks, however, have the potential to earn more money for the fortunate investor who purchased the security for the long term.

How much is all the gold in the world currently worth? As of 2012, records show the world's supply of gold was roughly 4 billion ounces. The most recently quoted price of gold was $1660.90 an ounce. At that price, there is approximately $6.6 trillion of gold trading on the markets, locked away in vaults or being kept or worn as jewelry. Let's assume you are now the sole owner of all the gold in the world. Now, as discussed above, this $6.6 trillion worth of gold will not generate additional returns for you. Over time, you can only expect a .3% compounding growth rate on this non-productive asset. However, as an investor, you elect instead to sell the gold and invest in reputable stocks. What would you be able to purchase? Using September 28, 2012 market caps as the base, you would be able to afford... get ready for this: 2 Apples, 1 Exxon Mobile, 2 Microsofts, 2 IBMs, all the farm land in America, and still have several billion dollars left over for spending money! All of the above mentioned assets are productive, and will produce billions of dollars worth of earnings to you over the long term. These companies, in the long term, will also be worth substantially more decades from now than they were when you purchased them originally. The 4 billion ounces of gold, however, will still remain 4 billion ounces of gold. This same concept can be applied to the small investor as well. If you intend to purchase one ounce of gold at $1700, you would be better off purchasing high quality securities with the same amount. The 1 ounce of gold will remain 1 ounce of gold 10 years from now. The price, assuming a 1% growth rate over those 10 years, would be $1877. However, assuming a 7% growth rate, the $1700 invested in the market would be worth $3670.20. Obviously, the stock investor would be better off putting the $1700 in the market.

Now, to be fair, gold will probably rise in value somewhat over the long term. This rise however, will pale in comparison to the enormous rise of common stocks over the same period. Investors will be quick to use 2008 as evidence of the merit behind investing in gold. To a certain extent, these investors are correct. The evidence shows that gold rose substantially over the course of 2007 to 2011. This is indicated by the chart below

This was due primarily to many of the aspects I mentioned before, including market uncertainty, government incompetence, a debt crisis in Europe and economic uncertainty in emerging markets. However, I would argue that stocks at the time were equally as attractive as gold. Purchasing stocks instead of gold during such market turmoil would reap substantial benefits for the long term. This is because stocks were trading at substantial discount to what they were actually worth. Over time, purchasing securities at a discount will exacerbate gains over the long term. Here is some simple math on the issue. Around the same period that gold was rapidly appreciating, financial shares were trading at bargain levels. Bank of America (NYSE:BAC), for instance, was trading at half of its book value. Instead of purchasing gold, the investor would have been better off investing in BAC due primarily to the fact that it was trading well below what it was worth.

If you have BAC stock trading with a market value of $10 and a book value of $10, a 10 to 12 percent increase in earnings will produce a similar 10% to 12% return for investors. Now let's assume that the payout ratio (the amount of dividends the company pays out to investors) is 50%. Under the above example, BAC would pay roughly $5 to $6 in dividends and retain the rest within the business. The retained earnings would likewise increase the book value, or overall net worth of the company. This increase in book value, at some point, will be reflected in the market price of the stock as the book value increases. When added up, this would result in the 10% to 12% return for investors (5% to 6% in book value appreciation and 5% to 6% in dividend return)

Now, let's assume BAC is trading at 150% of book value. The investor would still receive his 6% in book value appreciation (assuming the stock still trades at 150% of book value). However, the dividend return would be only 4% due to the $15 market price the investor paid ($10 book value x 150% price paid = $15). In this scenario, instead of returning the high of 12% mentioned above, the investor would only get 8% to 10%.

This math is reversed when a stock is bought below book value. As is currently the case with BAC, the stock trades at 50% of book value.

Now, some of you may be quick to point to the inability of investors to select carefully chosen common stock. This is a valid argument. Investors, in many cases, do not have the time, ability or inclination to examine common stocks to the degree that many experts do. As such, beginning investors rely heavily on information garnered from television, radio, or friends to assess the viability of a common stock. This can be quite costly to the investor, as history has proven. As such, beginning investors tend to forego the game of common stock selection and instead elect to purchase gold or bonds, believing them to be "safe." Both of which, as we examined in the beginning of the article are, in actuality, risky. These investments, over time, will pale in comparison to the growth that can be obtained through long-term common stock ownership. The solution, therefore, is to invest in exchange traded funds that mimic the movement of the overall market in general. ETFs provide the instant diversification that investors want without the added risk of potential loss. When purchased at the current price, ETFs such as SPY, VMO or QQQ can potentially provide the investor with the 7% historic returns of the market without the specialized knowledge needed to select stock individually. I detail this concept extensively in my article, "If You Can Beat Them, Why Join Them? ETFs As Viable Long Term Investments."

Finally, in the interest of gold supporters, there are many short-term investment uses for bonds and gold. Individuals approaching retirement, pension funds looking for income, those in retirement looking for income, insurance companies, and financial institutions all use bonds and commodities extensively. I have no quarrel with these uses. Gold is used in many short-term transactions as a hedge. High quality bonds are used for liquidity and short-term financing needs of large corporations. All of these functions are needed and therefore, warranted. However, for the long-term investor, gold has and will continue to prove very costly. It simply cannot compound over the long term, to the extend other productive assets can. As such, investments such as SGOL or GLD should not be used as viable, long-term investments.

I thank you for your time and I hope you enjoyed my article. I would be happy to entertain any comments, questions and concerns regarding any of the material presented in this article.

Disclosure: I am long SPY, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.