All around the world, shoppers have been scooping up deals, buying for loved ones and fighting mall frenzies. In another sector of the economy, hundreds of thousands of financial planners, advisers and brokers will begin the laborious process of balancing millions of portfolios and contemplating end-of-year transactions.
Gold and Modern Portfolio Theory
For nearly three decades the dominant investment strategy for investment portfolios has been the concept of Modern Portfolio Theory. Spurred by Markowitz’s Nobel-worthy research on diversification, the discipline asset allocation is the king of principles among portfolio managers and financial advisors.
At the core of this theory of asset allocation is the idea that each asset class and each investment within that class must be evaluated for its potential to generate a return. With the general adoption of MPT, many of today’s financial managers view gold as a “dead asset,” meaning it produces no direct return while it is being held. Therefore, their logic brings them to believe that “The optimum allocation to gold is always zero because its return is too low to be a real investment.”
Those Who Do Not Learn History…
What is extremely interesting about the above conclusion is that in the same article, the author observes:
Gold is a safe store of value but not an investment. Cash isn’t a safe store of value. When adjusting for inflation, $1 has dropped to just $0.06 in buying power over the last 200 years. Cash doesn’t pay you money and is not an investment. The correct asset allocation to dollars is also zero.
Note very carefully if you applied the concept of asset allocation to both cash and gold, you would not allow for holding any cash in your portfolio or as an asset! If cash and gold are both zero-asset investments, yet cash decreases significantly in value over time while gold does not decrease and may actually increase, then it stands to better reason that buying gold for a portfolio is both reasonable and valuable.
Where Cash Fails, Gold Excels
The very real problem here is that very few of today’s financial advisers, planners and managers are old enough to remember the 1970s in the United States. Even more significantly, a full decade of graduates from our finest institutions have never seen a Fed rate near 1 percent, much less 15 or 16 percent (surely a number they equate to the same probability as seeing ghosts and tooth fairies).
However, as George Santaya’s famous quote reminds us, “Those who cannot remember the past are doomed to repeat it.” While some cannot imagine a return to rampant inflation and a major crisis of confidence in paper currency, it is an error to ignore that possibility, no matter how small.
One of the most definitive works on the correlation and causation of fluctuations in gold prices and inflation levels was done by Erb and Harvey at Duke University. Their discussion of the Golden Constant, or the protection of purchasing power, that gold represents clearly shows that gold prices are determined by many factors, but driven by:
- Inflation
- Fear of and occurrence of financial crises
- Real interest rates
- Demand and supply
Gold and Inflation
There are literally volumes of information that show the correlation of gold to inflation over the centuries, and that gold is one asset that truly stores value, purchasing power, over time—even better than cash. While MPT might call for rejecting gold as a valuable asset to hold, it remains in the top of the ways to beat inflation.
This is the core fact that baffles many younger “financial experts” who do not see gold through the eyes of history, including very recent history.