Gold is known for providing diversification to your stock market portfolio, and for its effectiveness in hedging against crises and inflation. So to understand why you are not diversified in such a tried and proven asset, you need to consider the lack of information provided on the matter of gold as an investment, as I detailed in part 1 of this series. However, even those that are exposed to the information read or hear additional objections to investing in gold. Here is the most common.
Gold?! Gold does not yield
When you approach someone for advice on your plans to invest in gold, you may hear that gold “does not yield” as a reason to not invest in the precious metal. This statement immediately hits your “greed button”: If gold provides no dividends or cash flow, it must not be as good as McDonald’s shares, which do. This statement is either coming from a fundamental misunderstanding of what gold is and does, or it is a misdirection by someone who may know gold very well but prefers you don’t invest in it.
The short answer to this statement is that gold does not need to yield to provide you with protection and growth. Gold provides these benefits without yield. Here’s the longer explanation.
A stock or bond needs to yield (provide cash flow) to provide you with benefits that offset two of the downsides of stock or bond ownership in a publicly traded company:
1) Risk. You face risk when holding shares or bonds of any company.
2) Inflation. Your stocks and bonds need to overcome inflation, which is eating and gnawing away at the dollar-denominated value of these paper assets.
Once in a while, the stocks or bonds of one of the companies you hold may lose value because new technology made the company’s products or services redundant or irrelevant, because a competitor bested it, because of bad management decisions, etc. Since none of the companies that were in the New York stock exchange when it started exist today, you see that this will always happen, so offsetting this real risk with holding stocks and bonds is done by them providing you with extra growth to offset cyclical or specific losses.
Think about part of the yield you get from assets that give dividends or cash flow as providing something close to the concept of risk insurance, which you need to offset the real losses that may occur to stocks and bonds. Physical gold is a completely different asset than a stock or a bond because it carries no third-party risk. Once you hold physical gold, no technological advance will make it worthless, no hacker will take it away from you, and no CEO’s decisions can affect its value. So, gold does not have to provide extra growth to offset these specific losses that are typical to stocks and bonds.
Gold compared to stocks and bonds regarding inflation
Another concern with stock and bond ownership is that these paper assets are dollar-denominated, meaning they are tied to the dollar — the same dollar that has been consistently losing its purchasing power for the last 100 years. Since your stocks and bonds are priced in dollars, and since we have had some level of inflation over 99.9% of the time throughout our history, they must always yield and grow above and beyond their loss of purchasing power so that you don’t lose real return while owning them. So, another part of the yield you get from stocks and bonds is just the yield that allows you to stay in the same place and maintain your purchasing power.
Here’s an image that helps to understand this concept – a stock of a company is like an air balloon that is consistently being inflated in price by the company’s success. But the balloon has a pin-sized inflation hole that is constantly letting out air of purchasing power. If the company can put in more air than is escaping, you are faring well, if not, you lose real purchasing power.
Twenty years ago, you would have been able to buy a lot more things with $100,000 than today. That is why very few investments are worse than keeping your investment dollars in cash long-term. If you had invested your $100,000 in the Dow Jones index exactly 20 years ago when it was $9,600, your investment would be worth $362,000 today. Remember that part of this return is to offset risk, another part is to offset inflation, and the remaining part is growth. Before you get too excited, know that if you had invested your $100,000 in gold at the same time, your gold would be worth $607,000 today, and that is without taking into account the much lower fees of holding your physical gold (zero or close to zero) compared to holding stocks and bonds (1.5% a year on average for amounts below $250,000).
Here’s the kicker – gold does yield — it just yields in a different way than stocks and bonds. The physical amount of gold doesn’t grow on its own, just like the amount of shares or bonds does not grow, but gold’s purchasing power does over time. It is observed that gold does provide purchasing power growth above and beyond inflation at a rate of about 2% a year, and some economists tie it to improvements in technology. If my purchasing power is intact and technology raises the effectiveness in manufacturing, for example, I will be able to buy more effectively in the future with the same purchasing power.
This hidden yield is real and may explain why gold fared so well compared to the stock market over two decades with all the QE support the Fed has been providing the paper asset markets — and even when you look at its growth since 1971 and the cancellation of the gold standard. This additional purchasing power yield is important if you are considering leaving funds and assets to future generations.
Gold’s main purpose, in my eyes, is to provide the hedge that makes your portfolio perform better than it could without gold. And I would argue that, today, that hedge is more necessary than it was a few years ago.
Gold and the time we are in
Inflation, exploding global debt, pandemic recovery, lockdowns, China–US tensions… There is no doubt we are living in historic times.
“We’re in a period of great risk, and the most important thing is to know how to diversify well.” – Ray Dalio
Historically, during periods of great and extreme risks, like in the 1970s or after 2008, gold and silver were growing wildly in value. While that happened, the stock and bond portions of portfolios were free-falling. At that time, having enough gold in your portfolio would have offset these losses. Investors who hadn’t diversified with precious metals at that time lost a significant part of their nest egg.
This feature of gold as something akin to a financial insurance policy for periods of extreme risk and volatility is why I own a good portion of my portfolio in gold. You should consider protecting your purchasing power the same way.