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When the US went off the gold standard in 1971, things changed
August 26, 2011 — 5:08 AM UTC by Guest Columnist Brent Burns
Brooke’ Note: The gold bugs have been having an absolute field days – for months. But just because gold is going up doesn’t mean they’re necessarily right, or wrong. Here are some thoughts served cold about the precious metal that can help an advisor to think about it constructively as a potential investment.
Is gold a good investment? Maybe. Is it a good hedge against inflation? No. Does it protect against loss of value? No. Investors looking to protect value and hedge inflation should be looking at individual TIPS.
I don’t think I have ever seen conventional wisdom about an investment be so far off from reality. The performance of gold as an investment is completely unrelated to the role that many investors are told it plays in their portfolio. Many have been told that gold is a good hedge against inflation and that it is a safe haven to protect capital in turbulent markets. And it used to be true before President Nixon removed the US dollar from the gold standard in 1971.
But like the tie-dyed fashion of the time, those days are gone. Gold has shifted from an investment that protected value and hedged inflation for our grandparents to one that is purely a speculative investment. Once the price of gold, which had been fixed against the dollar, was allowed to float, its value changed with the momentum of the market. Gold could no longer protect value in a predictable way because its exchange rate to the dollar was no longer fixed. Also gone were the periodic adjustments to devalue the dollar relative to gold that protected against inflation.
Comparing gold and the S&P 500
To evaluate gold as an investment, we really only can look at what it had done since 1971. The chart below compares the performance of gold to the S&P 500 with inflation shown at the bottom. It is fair to say that both have significantly outperformed inflation over the period, but neither are particularly reliable hedges.
Over the hedge
Let’s be clear about the role of a true hedge. Investors often confuse an asset that is expected to grow at a rate that outpaces inflation with an investment that actually hedges inflation. Investopedia provides a good definition: An inflation hedge typically involves investing in an asset that is expected to maintain or increase its value over a specified period of time. Although gold and the S&P 500 both significantly outperformed inflation, they could not provide a reliable hedge over a specified time. In fact, gold had a period of 28 years in which it underperformed inflation.
TIPS – The best inflation hedge
Investors searching for an asset that can protect value and hedge inflation they need look no further than Treasury Inflation Protected Securities (TIPS). TIPS provided an investment that will provide consistent, predictable real return adjusted for inflation in a way that gold cannot. Setting aside whether CPI is an appropriate measure of inflation for individuals, TIPS return is directly tied to changes in inflation with a lag of less than 2 months.
Do not confuse individual TIPS and TIPS funds. Bond funds are a total-return vehicle that happens to invest in TIPS, but do not provide the predictable returns of an individual bond. Bond-fund returns are market driven and will decline when rates rise. Losses would completely swamp the inflation hedge.
To isolate the inflation hedge and provide reliable return of capital, investors need simply to buy individual TIPS and hold them to maturity. For retirees who have specific spending needs, they can time out maturities to match their withdrawals. The hedge for each year is nearly perfect, with the return of capital and coupon payments adjusted for CPI experienced over the time horizon. Value is protected and inflation is hedged.
Most other inflation hedges, like commodities and real estate, have a much more nebulous tie to inflation. The theory with those assets is that rising prices will be passed on to consumers and returns will adjust. Unfortunately, they are subject to numerous exogenous factors like natural disasters and market conditions that can negatively impact returns and eliminate any inflation hedge.
Gold – A speculative investment
Since 1971, the real purpose of investing in gold has not been to protect value or hedge inflation. It has been to provide diversification and total return. Gold is a speculative investment. Unlike stocks in companies that can generate profits and pay dividends, gold is a physical asset. It sits like a brick, because it is a brick. Returns are based only on what other investors are willing to pay for it (Tulip Mania?).
To say that gold returns are streaky is a bit of an understatement. Even as the lost decade in the S&P 500 turns 11 (from the high in 2000), it still isn’t half as long as the lost generation in gold (1980 to 2007). If you think it is hard to get clients to stay the course in stocks, think about how hard it is to convince them to hang in with an investment that can take up to 28 years to get back to its highs.
If the pattern since 1971 holds, gold has to be viewed as a long-term investment that languishes over long periods and delivers most of its return in short bursts. It may fit into an investor’s long-term plan, but it will neither deliver a reliable inflation hedge nor protect value in turbulent markets. It may perform well when other markets are correcting, which provides a diversification benefit. But TIPS are far more effective as a hedge for inflation risk and can protect the value of the investor’s capital if held to maturity.
Brent Burns is president and a founding partner of Asset Dedication LLC, a fixed income separate account manager in Mill Valley, Calif.
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