Financial Management \"Suddenly, Gold Isn\'t Looking so

Financial Management

"Suddenly, Gold Isn't Looking So Solid"

This article (Sommer, 2011) examines the advisability of including gold in a typical investment portfolio. The article analyzes arguments, both historical and current, in favor of and against investing in gold. The article concludes with a very qualified recommendation, advising investor caution.

Sommer's article debates the question of whether gold, given its high volatility, should be included in a typical investment portfolio. He presents arguments that there is no simple answer.

The popularity of gold is well established, with gold having served as the standard of the global monetary system until the 1970s. Even today, gold maintains a certain appeal during an era of wildly fluctuating financial values. Many consider gold a mainstream investment, as evidenced by the fact that a gold exchange-traded fund, SPDR Gold Shares, was the second-most popular ETF in the U.S. On April 30 (Sommer, 2011).

Yet, for all its popularity, gold behaves in many ways like just any other commodity, like oil, silver, wheat or pork bellies, subject to the vagaries of the markets and, recently, to an unusual level of volatility. It has dropped more than 4% during the month of May, after more than doubling in value since October 2008. Given these characteristics, does it make sense for the long-term investor to hold gold? (Sommer, 2011).

Leading asset management firms offer different answers. T. Rowe Price and Fidelity include allocations of gold and other commodities in their target-date mutual funds, that is, their standard portfolios that are intended to be all an investor needs until retirement or later. Vanguard, on the other hand, does not include gold or any other commodity in its target-date retirement funds or any other core funds. For a basic portfolio, Vanguard considers commodities to be superfluous and highly volatile. Sommer's article quotes Fran Kinniry, principal at Vanguard's Investment Strategy Group "… we've found that for the typical investor, you can get all the diversification you need without including any commodities at all" (Sommer, 2011).

Sommer's article quotes financial strategist Gary P. Brinson as saying that the role of gold in a diversified portfolio might be as a hedge against inflation, or as a hedge against a decline in the value of the dollar. However, at gold's current level, Brinson points out that "you're paying a very high price" for it. Vanguard's Kinniry argues that an allocation to international stocks would have hedged better against a dollar decline, but with much lower volatility.

Another argument in favor of putting up with the volatility of commodities like gold is that their long-term price trend is upward. Sommer counters that argument by pointing out that gold peaked in price in 1980 at $850 a troy ounce. If one factors in inflation, that amounts to a peak price of more than $2,400, almost a thousand dollars more than where gold actually trades today. So, after more than thirty years, an investor in gold would still be operating at a loss; that calculation does not even include the cost of storing and protecting the gold. Sommer concludes the article by answering the question whether gold is a worthwhile portfolio investment with a definite "Maybe" (Sommer, 2011).

Relevance to Financial Management

The discussion regarding the place of gold in an investment portfolio is particularly relevant given all the uncertainty of today's economy. Sommer's article provides insights into reasons opposing as well as favoring investing in gold, and debunks many of the traditional rationales put forward, raising doubts as to gold's suitability for an investment portfolio. Nevertheless, investment demand for gold remains high. A Wall Street Journal article (Cui & Hoyle, 2011) describes the World Gold Council report that China's investment demand for gold more than doubled in the first three months of the year. The report attributes the rising appetite for gold among the growing middle-class in China to fears of the country's growing inflation, as well as a search for new investments.

In addition to arguments previously discussed about portfolio investment in gold, Sullivan (2010) offers some additional insights. In contrast to the way in which fear of inflation and fear of a vulnerable dollar have typically driven demand for investment gold, the senior managing director at State Street Global Advisers, Jim Ross, points out that even as last year's concerns have subsided, buying hasn't diminished. There is also the argument that the cost of owning gold has been mitigated because interest rates are so low.

Sullivan points out additional drawbacks to holding gold: the first is that it does not pay a dividend, so there is no income stream. The second problem is that gold is taxed at a much higher capital gains rate. Because the Internal Revenue Service considers gold a collectible, gold is taxed at a rate of 28%, as opposed to the 15% capital gains tax for other securities (Sullivan, 2010).

Another analyst argues that fundamentals alone only partly explain the outsize gains made by gold in recent years. Hurlbert (2011) points out that, during the period since fears of hyperinflation caused bullion to rise to historic highs in 1980, gold is only 78% higher today, less than half the consumer price index's gain of 179% for the same period. However, over other periods, the relationship between gold and inflation is just the reverse, with bullion far outpacing the CPI; over the last decade gold gained 480% versus 11.8% for the CPI. Hurlbert goes on to show a weaker than expected correlation between gold bullion and the dollar, as well as gold and geopolitical uncertainty.