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Investing in Gold: Gold may be the most crowded trade around. TIPS provide better inflation protection.

Jan. 24, 2011 11:19 AM ETGLD, GCC
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Gold is shiny and makes nice jewelry, but as an investment it doesn’t impress me.
Gold has typically been endorsed as a sound investment during uncertain economic times or periods of inflation, but lately it is being touted as the choice investment for any scenario – inflation, deflation, recession, or expansion.
Consequently, more and more people are inquiring about the merits of investing in the precious metal. A decade of impressive returns has also boosted enthusiasm for gold among individual investors – the kind of performance chasing that is a bearish sign in and of itself. From where I’m sitting, gold looks like the most crowded trade around.
Over the past decade, gold prices have benefited from the growing presence of emerging nations in the global economy. The rising purchasing power within emerging market nations has inevitably driven up the demand (and price) for scarce commodities, as well as the need for emerging market central banks to accumulate gold reserves. This secular trend justifies gold’s magnificent run up to a point, but I believe we’ve passed that point.
There are a myriad of catalysts that could rattle prices. The biggest risk to gold prices is that the Fed stops flooding the financial system with liquidity and the dollar appreciates. Rising interest rates provide competition for non-income producing assets like gold – gold pays no interest and even costs something to store. 
Another risk to gold prices is that stock markets could surprise to the upside, reducing investors’ interest in real assets like gold. It’s also possible, although hard to imagine, that the U.S. government finally addresses the deficit, which would put upward pressure on the dollar and weigh on gold.
Given the Fed’s unprecedented monetary stimulus, the risk for inflation in the longer term is quite real and one could easily argue that buying gold today protects against potential inflation down the road. While that may be true, I think TIPS (Treasury Inflation Protected Securities) make more sense as an inflation hedge.
TIPS pay a fixed coupon rate, but the principal value of the security adjusts semiannually based on the change in the consumer price index (CPI). Historically, TIPS have a lower average annual return than gold but are much less volatile. The table below compares the average annual return, standard deviation (a measure of volatility), and Sharpe ratio (measure of excess return per unit of risk) for gold, the CRB Commodity Price Index, and TIPS.

TIPS have a similar return to gold, but are far less volatile.
As you can see, gold has a higher average annual return, but is far more volatile than TIPS. In addition, gold is near an all-time high, which makes the prospect of high returns over the next several years seems less likely. 
Given the frothiness of the gold market and its historical volatility, TIPS look like a better bet for those looking to hedge against inflation. Not only are TIPS less volatile, you would be hard pressed to find another investment with a guarantee by the U.S. government on growth of your purchasing power. 
If not gold as an inflation hedge, then what about a diversified basket of commodities? Using the CRB Commodity Price Index, an equal-weighted basket of 17 commodities, we see that commodities have a significantly lower return than TIPS with more than three times the volatility. As a result, I also view TIPS as a superior inflation hedge to commodities.

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

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