I really liked this piece by Matt DiLallo on why gold is so hated by Warren Buffett. He provides the juicy details, but I’ll give you the quick and dirty rundown:
- Gold is an unproductive asset.
- Gold is valuable largely because people believe it’s valuable.
It’s not that Buffett is an ideologue or just on some anti gold rampage. I think there are some logical and great lessons to be learned here:
- We build wealth by increasing our own production. That is, we become more valuable to others within society when we do things that they find valuable. This is why society rewards great innovators and people who tend to work hard.
- Betting on commodities like gold is often a bearish bet against human productivity and innovation. When you buy a block of gold you are essentially buying an insurance asset whose value will increase if the value of dollars collapses or falls. In other words, you are betting directly against the ability of US workers to produce and maintain the value of the dollar.
- Betting on gold is largely a bet on faith. That is, you are betting on the idea that someone else will believe gold is more valuable in the future. Although gold is valuable to some degree as a commodity there is also a substantial portion of the population who wants to own gold because it is viewed as money or protection against paper money. I’ve referred to this in the past as a “faith put”, a premium in the price that inflates its value due to sheer faith.
I don’t mean to rant against gold. I just think that there are some fundamental reasons to keep gold in the proper perspective when we consider its value as a portion of our asset holdings. In my view, it’s not the type of asset you want to build a portfolio around due to the aforementioned thoughts….
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.
You and Mr Buffett do not understand gold. People buy gold to protect themselves against a predatory financial industry and a government who protects them. Simple as that. Can you spell “trust”?
Just continue rigging markets, statistics, commodities, gold and silver prices and see what happens. People know damn well, unfortunately for you and Mr. Buffett
“Gold is valuable largely because people believe it’s valuable.” I agree with this one.
However, “you are betting directly against the ability of US workers to produce and maintain the value of the dollar”
Betting against? The Fed has an inflation target of 2% and has a phobia for deflation and it can print dollar.. Coca cola used to cost 5cent each etc..
Given the last 100 year history, of course an ounce of gold will cost more in nominal dollar 50 years from now, whether this is at a slower pace/higher pace compared to S&P 500 that is another matter.
Peter Wilson Close
“We build wealth by increasing our own production.” That may very well be the precursor of increased wealth but without an increase in the money supply it doesn’t matter how many sheds of produce or products you have or by how much you increase productivity you will not see increased wealth – more likely you’ll see deflation and ongoing recession/depression. Our historical problem is that the vital increase in money supply has been provided as debt by commercial banks when it should have been provided debt-free as an asset by the sovereign state . OK it’s tough on the Eurozone since their sovereignty has been confiscated and signed away at Maastricht.
“Gold is an unproductive asset”
Gold crowns are very productive assets.
Tend to agree on every point. And would add that insuring a bet that no one can pick the winner of every ncaa tournament game is equally unproductive. ; ) (and gold does have one use which is its lack of correlation to the stocks, bonds and dollars)
So I assume you feel the same way about art, collectibles, luxury real estate, etc?
I agree on your point #2 but don’t see gold or commodities as an “evil”. There are folks in the death of the dollar and bond bubble camp who use hyperbole as an investment thesis. But, gold behaves like hedge that is “difficult” to value. And there are different types of hedges we might purchase for inflation, lack of economic growth, deflation etc (vix, shorts, calls/puts, bonds, tips, commodities and even the reserve currency). Gold is one of them.
Further, I think point #3 is the case with any financial asset. People believed stocks where “extremely” valuable at the “height” of the dotcom and 1929 bubble and buyers near the top believed they could off load them on someone else for an even higher price. And people believed that houses were valuable in 2007 but today view them as less valuable. The same with gold in 2011 versus today. Valuation is tied to perception.
The big difference, is that that stocks might pay a dividend or generate earnings (because those companies produce a valued output) which allow you to put a fair “value” compared to gold. That said, one could sell call options against gold and generate “productive” income and determine the value of gold in that way. But, I’d suspect, the fair value of gold based on the discounted cash low of a stream of call option income is much lower then the current price. However, I think both methods will show that stocks and gold are overvalued but perhaps gold is “more” overvalued.
If the art/collectibles was not purchased for personal gratification but instead to diversify their holdings in hopes selling that collectible to some sucker at a higher price then then I would agree.
In that case, collectibles are simply another form of hoarding unproductive assets that generate nothing for the economy and locks up production. That is, purchasing fine art and collectibles doesn’t “produce” wealth by increasing our own production or the aggregate economies income. Though one might open a gallery to generate an income stream for example. [I’d be curious to know the size of savings for speculation that went into collectibles compared to the savings for speculation that is funnelled in commodities].
As I said, gold is a form of insurance. But you can buy insurance on your financial assets in safer ways than owning rocks….
Depends, but in general, art and collectibles tend to generate very poor returns.
Maybe someone is going to figure out that art is as “useless” as commodities and then create an closed end fund (for liquidity reason) and off load their collection on the public. I’m surprised it hasn’t happened yet.
But more seriously, I think art and collectibles trend is more a function of the the increase in wealth inequality across the world. The ultra rich have to spend their “savings” on something. Buffett sticks to well run companies but others speculate in other things.
“But you can buy insurance on your financial assets in safer ways than owning rocks….”
– Is this true? “safe” is a relative word of course, as people tend to view risk differently, but for the sake of discussion I am personally interested in a way to buy insurance that doesn’t have counterparty risk. Can you provide any examples?
I for one, believe that derivatives are a major problem; I’ve heard estimates of $1.4 Quadrillion. Conveniently, Buffet agrees with me…..I believe he calls the “Weapons of mass destruction”. As such, I have an allocation to gold and silver because its the only way that I can be 100% sure that my “insurance” isn’t someone else’s liability. In other words, if I buy puts or swaps, not only does it become very expensive over time, I also can’t be 100% sure that the counterparty will be able to pay out on my insurance at precisely the time I would need it (on the off chance that 2008 happens again).
I would appreciate if anybody could name me a single “insurance” play without counterparty risk and a history of performing well in times of chaos. Not being sarcastic here or a smart alek, this is a sincere question/request. Thanks.
Why is an increase in money supply necessary? why couldn’t the value/price of the currency just increase. In other words, if a nation increases its productivity and the money supply is fixed….why could the value/price of each unit of currency increase commensurately?
Peter Wilson Close
If the buying power of currencies rises then the price of goods falls. That’s what’s called deflation! – and it causes the relative value of debt to escalate prolonging recession and culminating in on-going depression.
The trouble with our dysfunctional monetary banking system is that we have allowed commercial banks to create 97% of our money as debt to themselves with the result that a stable economy is not possible because inflation is required to progressively dissipate the impact of the debt.
Gold like cash is a unique hedge because unlike options, or bonds or financial hedges it has infinite duration. But gold like cash also faces a hidden carrying cost (storage) unless you say keep it at home in which you face a risk of theft.
Also, in the chaos of 2008 gold didn’t perform as well as treasuries or cash (another hedge) and gold was liquidated for those “worthless” USD full of so called counter party risk. Though to be fair post crisis gold did recover those losses (and yet so did stocks). Maybe cash and treasuries can be useful “hedge” and probably gold too? Of course all of these have some element of risk – even gold.
With all respect, insurance companies form an integral part of the financial industry (ref: AIG). To protect yourself from the financial industry by investing in the same industry just does not make sense.
and think of a $40 million Francis Bacon – technically, you could almost roll the canvas and travel with it – much easier than moving $40m worth of gold. Hence why China became the second market in the world for contemporary art. You don’t trust your government? park a few paintings in a swiss vault
more comments from you – PLEASE!
Yes deflation causes a problem for nominally denominated debt contracts, but it is interesting to note that, in principal , that could be resolved by having them inflation/deflation linked.
maybe not – if a persons debt burden went up in line with inflation , that would be a seriouse problem in itself
Peter Wilson Close
But much of the debt shouldn’t be there in the first place! I’m not suggesting full reserve banking like Positive Money propose but if government capital spending was financed with new debt free money – albeit with a fiscal brake to curb electoral bribery – we wouldn’t be taxing £100bn a year out of the economy funding treasury bonds/gilts. Nor would we be saddled with financing ludicrous, obscenely exorbitant PFI projects! With the resulting lower taxation and a recovering economy it should be possible to achieve some realistically beneficial real term wage inflation that would lift consumers out of their credit card dependent stranglehold.
Buying insurance on a portfolio doesn’t necessarily involve an insurance company. If you hate the finance sector so much then why not just short it? That would provide you with some insurance against it….Why do you have to buy an unproductive rock as insurance?
Gold can be used as a monetary tool by central banks to control currency.
In below chart, Gold was used by FED to impact Dollar value as needed in US recession periods. You can see some interesting things about GOLD and Dollar:
Dollar going up and Gold going down during recession periods 1980s and 2007-8.
Peter Wilson Close
That would indeed be a problem but in fact that in itself is part of the current malaise causing on-going and possibly interminable depression. Incidentally I don’t believe the figures that indicate that the GDP has over-taken the 2007/8 peak! We live in a mature consumer economy that is driven by the spending power of the consumer and as such pushing austerity through cutting benefits will exacerbate the problem! We urgently need some wage inflation together with lower taxation and the only way that can be delivered is through changing the financial/money creation system. believe me, i have looked at the situation in depth and every other “solution” is flawed if not blatantly counter-productive!
I tend to agree and would add if we start with
– real economic growth (productivity improvements) are deflationary as prices fall (i.e TV prices continue to fall)
– nominal economic growth (credit/money supply fuelled) leads to general prices increase
The economy is an aggregate of those two opposing forces with prices in some areas deflating and others inflating. The CPI is an imperfect measure of the price inflation. And provided the real gdp growth rate is greater then CPI then things are “ok” in aggregate in the economy.
That said, there are pockets of the economy that will be hurt by this situation. That is, real wages need to keep pace with real economic growth so the aggregate society can pay off their debts (and not just the most well off). That part is currently missing.
Further, imagine if we had tremendous economic productivity with rapidly falling prices (let’s say we create fusion energy to replace oil at $0.01 instead of $90). Sales might fall but profits would surge. And so long as the “fair” share of the productivity improvements go to the workers real wages then everyone can still pay off debts. [I think everything here is correct]. That said, if we get credit deflation with a shrinking economy then that leads to price deflation then all bets are off as that is a tricky situation for everyone.
Peter Wilson Close
I think I agree with everything you say but you don’t address the fundamental problem that is the dysfunctional unsustainable financial system which is the cause of the current economic hiatus.
I do think we will crack nuclear fusion soon but the cynic in me suspects that the benefits will be far from evenly spread!
I have no clue how to solve inequality. I view rising debt levels as a symptom of the wage inequality rather then the problem. That is rising credit is not a problem so long wages keep pace.
Free markets will resolve inequality over a long enough period through force as the bottom part of society rebels. Or because of the instability of having a 1% accumulating all the wealth and strangling the economy. That might take many years to play out. That said, the government can try to force that outcome through tax changes or legal changes but I’m not sure people like the idea of big government.
Peter Wilson Close
Over the last few decades – no idea how many! – we have moved into a different ball game: The wage earner/ benefit recipient/ taxpayer is the customer in a consumer-led society. therefore the job will have to be sorted or the whole thing will stagnate!
That is a good one, Cowpoke!
“Gold is valuable largely because people believe it’s valuable”
Pragmatic capitalism is not so pragmatic. Read the sentence again and think about its meaning. Evth else is valuable because people believe so, not only gold.
i wonder how many thousands of years ago this was first said.
but yes paper is a much more valuable asset. lol
Fine art, an unproductive asset, is up 300% in the last ten years. Classic cars, hardly a very productive asset, are up 500%. Productive/unproductive, does not matter. It is all about supply and demand.
In the name of Mike Myer’s SNL Sprocket’s character Dieter: “Your story has become tiresome.”
Seriously, I fail to see the point of these missives on gold. It’s boring. The goldbugs won’t change their minds. People who hate gold will continue to hate gold. Most people don’t care about it. The Austrians’ warnings are dismissed and mocked. When the gold price is down, this points you make confirm people’s bias against gold; when the gold price is going up, your points are ignored amidst the goldbugs’ triumphant gloating.
Have said all that, and being aware of my own apathy toward gold, it may be possible that there is a short term bottom forming. I think I am going to buy myself some gold tonight.
If we are talking about a medium of exchange, I’ll take the paper for two reasons. First, I don’t feel like lugging heavy rocks to the store. Second, the store wouldn’t even accept them anyway.
Gold is not productive, gold also doesn’t diminish, simple as that. It’s cool to invest in a great company, but you are still placing a bet on that the company is a great company and has a fair valuation. lehman bro looked like a great company, enron looked like a great company, and nokia, blackberry. It’s cool to invest in indexes, but you still need to be smart on what index and when to invest. If you invested in Nikkei in 1990, too bad i just don’t see how you can outperform gold even in the long run. Why companies in Nikkei not great, how would a person know that? It’s cool to invest in treasuries, there’s little chance of default, but what are they yielding now? Does the yield really outweights the risk for inflation, war, etc.
Gold is not money, but it’s second best to major currencies in term of exchanging goods, it’s not productive, but it also has no risk of diminishing, it’s a good hedge for inflation, and it’s mobile, accepted in nearly all countries, can you name another financial asset that’s similar to these qualities of gold?
Just run the following tests: what was an optimal (highest Sharpe ratio, highest return, lowest risk) allocation of gold in a portfolio consisting of:
a) stocks only (SPX TR)
b) 50/50 share of stocks (SPX TR) and bonds (10 Y US Treasuries)
If you run it starting in 1970 (since gold became something different than the US dollar) you’ll get approximately:
a) optimal allocation of 35%/25%/35% for SR/ highest return/ lowest risk (stocks only)
b) optimal allocation of 20%/30%/15% for SR/ highest return/ lowest risk (stocks/bonds)
If you want to disagree with empirical data for the longest possible time series, fine. You’re an ideologue then, not an empiricist.
Pls bear in mind you’re running the tests when 2 year’s return for gold has been -30% and for SPXTR +45%.
I don’t follow. Your allocations don’t add up.
I have no doubt that gold has provided substantial diversification over the last 40 years. But using a rear view mirror approach does not make you an empiricist. It makes you data miner.
In my opinion, the value of gold increases in large part because people lack faith in the US Dollar. Now, if you think that belief will persist forever then fine. But I don’t think gold, as a form of money, is necessarily here to stay. And that means that gold’s value as a medium of exchange will be reduced as technology renders it flawed.
I am not trying to be an ideologue about this. I am trying to approach all of this from an operational understanding in a way that helps me make more logical decisions. If you think it’s logical to effectively bet on the demise of the USD then that’s your prerogative. Reasonable people can disagree….
Not so. Food, water, clothes, electricity – these all have practical uses, practical value.
While gold does have some practical (industrial) uses, it’s not generally used for that.
Thank you for your reply 🙂
1) Using full historically available data sample does not make one a data miner. Only using a sub-period does.
2) Using one currency (out of ~180 currently existing), however does make one a data miner, even it it supports as much as 20-25 of world’s GDP. A good, full analysis would look at gold’s return in all the world currencies over the past 50 or 100 years (if we want to have a 1% or 2% annual accuracy, given the propensity of currencies to go to zero.)
3) Comparing gold to US Equities has been a huge concession and data mining on my side (negative for gold, positive for equities). As you know US Equities have been one of the star performers of the last 100+ years. Only 2 countries have delivered better results, 17 have delivered worse.
I am not basing my thesis on US dollar’s demise. I only observe that for currently existing currencies (176 of them) the median age is 39 years, while for those that ceased to exist (some 599 of them) the median age of death is 15 years.
So, 99.5% of currencies, 95% of world’s population and 75-80% of world’s GDP is having a very different experience than people living in the US. And you can not blame them for buying gold. Especially if it delivered much better return than USD over the past 10-15 years, and slighthly better than USD over the past 20-40 years – allowing for the fact that they would not have access to US T-Bills/T-Bonds rates.
Can you explain to me why lack of faith (say, in USD) is a bad thing? I always thought that knowledge is based on evidence, faith is not.
To put it in another way:
You get to chose between two currency systems:
1) one that keeps its real value over full data sample (2600 years at least, and possibly as much as as 5000 years) and,
2) one that has:
a) 77% failure rate rate (599/775) over the first 15 years on average, over which it delivers -100% real return, and
b) 23% survival rate of unknown longevity during which it delivers some real return.
Question: what is an expected return on the 23% of instances that are to compensate for 77% of instances where you lose 100%?
Don’t know, but pretty sure much, much, much more than what they deliver. Or what gold delivers.
I guess my concern with your view is that it is inherently backward looking. It kind of reminds me of what most “passive indexers” do. They run some backtests on certain time periods, conclude that stocks basically always go up and then construct a “buy and hold” asset allocation around this. Except you’re using gold as the historical “always goes up” input.
I think a smart asset allocator has to be more forward looking and has to think about how the landscape of the world could change in the future. Is gold going to continue to rise for the reasons that it has in the past? My argument would be no. I don’t really care what it has done in the past. That’s rather meaningless even if there’s thousands of years worth of data. People who just look to the past and project future returns are being sloppy in my opinion.
And none of this is to say that having a lack of faith in the USD is necessarily bad. It’s fine to question the validity of the USD. It could even be fine to hedge against it with gold or other insurance products. I personally am not worried about the USD in my lifetime (at least at present) so I don’t think that’s necessarily rational. But that could change and I could certainly be wrong….
Good, good – good discussion there 🙂
Now, nowhere did I claim that “gold always goes up”. As we all know it had a terrible time in 1981-1999, it was essentially flat-to-down when nearly all other asset classes went up. In fact, in times of high real interest rates gold was a lousy investment (as it should be) and I would love to experience such a time and short it. But when we look back in history, such times are few and far in between, and this is what makes gold a reasonable investment. Not excellent, not very good – just good or “reasonable”. In some sense approaching money or currencies (in the longer term) is not that complicated. You just want a money/currency that is highly transactable and keeps its real value over time.
I have read a lot of what you wrote and had an impression that you are a reasonable and rational person. I totally agree that an asset allocator has to be forward looking. But when you form your view of the future you have to use data and experience that is inherently backward-looking. This is just a basic Bayesian approach. If you wish to discard the longest time series on hand, you need to have pretty good evidence to support that. As Bayesians are prone to say “extraordinary claims need extraordinary evidence”.
So, if you claim that one special fiat currency out of several hundreds will necessarily keep its value in real terms, I’d like to see the evidence to support it. What I see is to the contrary – USD has lost real value over the past 17 years, even if one invested in US Treasury Bills (which are not really risk-free, but let’s conversationally assume – very close to it at the moment)
So, we do not need the evidence of thousands of currencies and years, just most recent fifteen or so years, that form most of our adult life experience. Why would a reasonable person discard it? What’s the reason and evidence for doing so?
I’ll be happy to hear 🙂
Yes, good discussion. Thanks for being so thoughtful. I have no problem with allocating some assets to gold and commodities. I guess my main aversion to gold and commodities is that they are not inherently productive assets. They are inputs in the capital structure. If someone wants to use commodities as hedging vehicles then that’s fine. But I would not construct a portfolio based around gold because it’s not a productive asset.
I hope that summarizes my position more succinctly.
Cullen, nice piece. I’m no financial whiz, but It seems that the reasons people cite to invest in gold all require them to ignore these very legitimate points about the nature of gold. It seems to me that Gold can only serve as insurance or a store of value if people believe it does – it’s only marginally different than fiat money, or glass beads, because none of these have any intrinsic value, all rely on trust to function effectively – can’t eat them, can’t use them to ski or build a house. Well, I guess you could smoke the money, but I don’t think that would be very pleasurable, nor profitable. The prime difference I think is that you have a limited ability to grow the supply of gold, while paper money and glass beads are cheap to reproduce. However, w/r/t intrinsic value, would it be out of bounds to suggest that a farm has continuing value to any person who likes to eat and is close enough to receive the produce grown?
My understanding is that those types of returns tend to be difficult to realize and highly inconsistent. I have a lot of low value baseball cards I bought when I was ten to twelve years old. The returns are not so encouraging. The point being, if I had picked something with an intrinsic return, I’d have done much better (but I’m happy to have my Cal Ripken rookie card!)
That’s not always the case, Cullen. The classic case of gold proving to be a superior type of insurance is the experience of European Jews prior to and during World War II. Many of their legal titles of ownership to real property and financial assets were confiscated by Germany or its allies. For those who were able to migrate out in time, the only valuable assets most of them were able to bring with them were gold and jewelry. So, for an investor who has a very negative view on the safety of assets from government confiscation, gold makes perfect sense.
Ah yes, the “just invest” claptrap. GM, Lehman, Enron, WaMu, and Worldcom were ALL “productive” assets. Gold has never gone bankrupt. I am an expert on my occupation, not equities, why would I want to play “the game” against experts on stock markets?
Should I hold dollars? The govt (actually, the fed) ADMITS they are shooting for a -2% return on cash. Casino craps is better at a -1.5% return! Bonds? By any real world accounting standard (GAAP) our govt is bankrupt….not gonna loan them money. CDs? Again, the -2% thing. Real estate? I live in a low tax state and I still have to pay a 0.5% dividend to the govt (property tax) every year; what kind of investment pays a negative dividend?
Worldcom had an intrinsic return.
Geez….I tried to sell some bananas I had at the house, but there were no takers. I could sell my gold in 10min at any coin shop, pawn shop or jeweler.
Don’t forget to buy insurance on your insurance, because AIG may go bust AGAIN.
Because it’s a rigged game. With the touch of a (bailout) button, a bureaucrat can turn a winner short into a loser.
With all due respect to Mr. Buffett, fiat currency and stock certificates are valuable largely because people believe they’re valuable.
Sure, but that faith is backed up by the fact that you can also purchase output with it. Fiat money is the primary medium of exchange which gives you access to output….
you would have made a bad investment. gold is up 500% vs the dollar over the last 11 years.
Money is not an investment.
so you’ve got nothing? lol
…and everything is an investment.
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