Gold is one of those “alternatives” to stock market investment that seem to get more attention when economic prospects seem most dicey. Maybe the real question isn’t whether gold is a terrific asset class, but whether gold or any alternative instrument really offers safe harbour from shaky capital markets and economic catastrophe.
Can investors reliably protect themselves from risk and still capture capital market returns? Is this the legitimate goal of the long-term investor?
Principles of modern finance suggest that the primary components of a diversified portfolio should have expected return. Only projected earnings can generate expected return. Because gold doesn’t produce anything, it has no projected earnings stream and therefore no expected return. Gold is just a metal.
So with good cause, people rarely talk about gold as an asset class with positive expected return. Instead they talk about it as a “diversifier”—some form of protection against economic harm. Specifically, investors seem to view gold as a hedge against inflation and currency devaluation. Maybe they see gold itself as de facto currency. After all, gold has been used on and off as money across many civilizations through history, sometimes surviving other local coin.
Uncertainty is scary, but it’s a fact of life investors accept. Fortunately, modern finance gives us a way to parse uncertainty. Asset pricing teaches us that some risks are more worth taking than others. The risks most worth taking are those that come with expected return. With stocks and bonds, investors put their money to work in the capital economy. The money they invest helps power enterprises that generate growth and productivity. This is what earns expected return. Simple commodities like gold don’t create economic growth. “Investing” in gold is at some level just speculating: you hope the price will go up.
Understandably, people want to flee uncertainty. But modern finance teaches us that this is not the task of the investor. Periods of volatility weed speculators out from investors. A belief in the efficacy of markets keeps us from confusing the inevitable periods of poor performance with a failure of markets and capitalism. The disciplined, long-term investor does not react to short-term variance in markets by seeking alternative, protective “asset classes,” but instead develops a cynical muscle that recognises the urge to flee as a call to greater vigilance. Long-term investors accept—even embrace—the risk that comes with expected return.
There’s nothing wrong with putting some assets in gold or any other commodity as long it’s not in reaction to recent markets or an arbitrary shift away from the instruments with expected return that comprise the bulk of a plan. Understanding what you’re doing and why is the real key to successful investing. Principles of modern finance help point the way by offering a theoretical framework for distinguishing investing from speculating. They clarify our motives so that we can make clear, rational decisions and stick to the fundamentals of long-term investing—in the face of a gold rush or other forms of false refuge.