I’m really rampaging against gold this week, but I feel like many of these concepts are really important. So I apologize in advance.
Last week at the Orcam site I published what I believe is an incredibly important piece on the concept of investing. Basically, I summarized the fact that none of us are really “investing” in secondary markets. That is, when you buy stocks on an exchange you are not really an investor. You are just allocating your savings. Real investment is done on primary markets via IPOs or via private equity or through private purchases not consumed for the purpose of future production. What most of us do through our portfolios is allocate savings. You obtain income that goes unspent and you then allocate that into various asset classes like stocks and bonds. But these assets serve very different purposes in terms of portfolio construction.
I won’t go into detail about portfolio construction and the role behind each asset class (that is a far larger project than I have the time or space for here), but I do want to touch on the role of gold. Gold is mostly an unproductive, non-income producing asset whose value has elements grounded in its marginal productive uses, but is primarily valued based on its utility as an alternative medium of exchange (form of money) to fiat money.
I believe your saving portfolio (NOT YOUR INVESTMENT PORTFOLIO AS MOST PEOPLE INCORRECTLY REFER TO IT) should achieve two primary purposes:
1. Protect against the risk of permanent loss.
2. Protect against the risk of purchasing power loss.
Different assets achieve these goals in varying ways. For instance, purchasing shares of stock in a diversified portfolio achieves both protection against the risk of permanent loss AND protection against the risk of purchasing power loss. I would argue, however, that gold only achieves the second of these two goals. Because gold has a heavily embedded “faith put” there is the potential for gold to serve as a very poor protector against the risk of permanent loss. In other words, if everyone in the world agreed that gold is not an alternative form of money its value would likely crater. When you buy gold you are not really investing (in any sense of the word). If anything, you are allocating your savings in a manner that serves as a hedge in your portfolio against the potential loss of purchasing power.
This doesn’t mean gold plays no role in a portfolio or even that I view it as a useless asset. But I believe it’s important to understand how different assets fit in the matrix of portfolio construction. Because gold’s value is largely based on this “faith put” I would argue that gold serves as a riskier form of asset than many other asset classes and therefore warrants a far lower allocation when considering portfolio construction.
* Addendum – I am not saying that equities cannot suffer permanent loss. Rather, equities ultimately represent output and human beings ultimately make progress over the long-term which increases total output. So, in short timeframes equities can serve as a poor protector against permanent loss, but over longer timeframes serve as a superb protector against permanent loss.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.