History proves protecting wealth by buying gold is folly, writes Chris Worthington, senior economist at Gareth Morgan Investments.
History abounds with the occasional fortune and frequent ruin of explorers, prospectors and alchemists who have sought wealth through gold.
Unfortunately, "conservative investors" may join that list in future tales. Such is the folly in the misconception that safety can be found by concentrating investments in an asset that should be labelled "high-risk".
There's no disputing that we are emerging from a scary period from the perspective of safeguarding wealth. Sharemarkets crashed; finance companies vanished; and even conservative banks teetered.
What's an investor to do? Even money under the mattress is no panacea in an age of quantitative easing, if one believes that runaway inflation will make today's paper money tomorrow's toilet paper.
Hence the allure of gold, history's reigning champion as a store of value. And it's not just the perception of safety. Gold has had quite a run in the past eight years, up 18 per cent a year in real terms.
The past year has brought frequent headlines announcing new record highs in the nominal price of gold.
So what has been driving this meteoric rise, especially over the past few years? A number of reasons are given, most of which can be applied broadly to all commodities.
Low interest rates mean that the opportunity cost of holding gold (which pays no interest) is small. Expectations of rising inflation or even fears of hyperinflation make hard commodities like gold appealing as a store of real value.
The "currency wars" - whereby major countries are trying to weaken their currency simultaneously - are cited as another source of support for gold as an alternative currency that can't be debased.
In essence, this is the inflation argument again - if countries all try to devalue simultaneously, the outcome can only be higher inflation. However, sovereign wealth funds may be driving up the price of gold as they try to diversify out of traditional holdings of government bonds in "devaluing" currencies.
Of course, as the gold price is denominated in US dollars, it follows that the price of gold expressed in US dollars must increase if the US dollar weakens to maintain global equilibrium. New Zealand gold investors might be surprised to learn that gold, in NZD terms, is actually down some 12 per cent from the peak in March last year.
The second main argument is that gold is somehow special - a safe haven against financial crises, sovereign debt crises and coming apocalypses. From that viewpoint, events of recent years demand a much higher gold price.
But empirically, the above arguments are flimsy. Let's begin with the pernicious claim that gold is a "safe" asset. Nothing could be further from the truth under any conventional measure of safety. During the free-floating gold era (1970 onwards) gold has been about 20 per cent more volatile than equity markets, and far, far more volatile than investments in bonds or cash.
Furthermore, the gold price distribution has even larger "fat tails" than equity markets. The stock market crashes that investors dread are actually more likely to occur in the gold market. The historic data bears this out - the single-worst month for gold saw a 23 per cent fall (in March 1980), versus a 21 per cent fall in the S&P500 (in October 1987).
Despite popular perception, gold has no special properties in times of crisis. In general, there is no relationship between equity markets and gold. Whether markets are crashing or rallying has little implication for the yellow metal, in contrast to things like government bonds that tend to rally in market crashes.
Forecasters who believe that financial Armageddon is around the corner would be better off avoiding gold in favour of bonds, or simply shorting equity markets.
The long-term performance record of gold should instantly give pause to investors seeking to safeguard their retirement purchasing power. The losses borne by investors who bought at the last gold price peak (and still the true record-high in real terms) are mind-boggling.
From the peak in 1980 to the low in 2001 (which most would consider as a long-term investment horizon), gold prices fell 87 per cent in real terms.
And to be generous, I haven't deducted transaction and storage costs over this period. Even eight years into the rally, investors are still 45 per cent below the high-water mark.
The inflation argument for gold is likewise ill-supported. The correlation between inflation movements and gold price movements is low, especially in the modern inflation-targeting era.
Even advance knowledge of inflation would give you very little predictive power over the gold price.
The last eight years bears this out - US inflation, whether measured by the actual CPI, derivative contract expectations or forecaster surveys, is lower now and expected to remain lower than when gold started its rally.
Despite the inflationary scare-stories of goldbugs, the real risk at the moment is deflation because of the huge spare capacity and high unemployment in the developed world.
No, the most likely explanation for gold's rise is simply that it's a commodity like any other, in a period in which China's rapid growth has sucked up a fast-growing proportion of the world's resources.
Copper and oil, useful industrially though not as pretty to wear, have soared in price in a similar fashion to gold over the same period. Soft (that is, perishable) commodity prices have also climbed, showing that protection from inflation cannot be the sole reason for commodity price increases.
So what place does gold have in a growth investment portfolio? I would argue a small one at best, as part of a broader commodity exposure. Commodities, as an asset class, have provided decent, if unspectacular, historical returns (once costs are properly accounted for) and a good source of diversification for equity and bond holdings.
However, that correlation to equities has been increasing and while the Chinese growth story has a while to run yet, it may well be possible that the lion's share of commodity price gains are now behind us.
But the high inherent risk in gold makes it anathema to the conservative investor. Ironically, those with concentrated holdings are unwittingly taking on the huge risk of the wealth destruction they seek to avoid.
