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Will Gold Shine Again?

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Gold's tangibility makes it seem impervious to the whims of politics, nature, and time, as opposed to paper assets such as stocks and bonds.

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Gold is an important but very different asset class that competes with stocks and bonds, and although it falls in the commodities asset class I'd like to briefly touch upon it in the following discussion. Unlike stocks and bonds, its main attractions are scarcity, durability, and resistance to oxidation-it simply never stops shining. In fact, most of the gold ever mined is still around today. It is exhibited in museums, worn as jewelry, and buried deep in the vaults of the central banks. Peter Bernstein, in his The Power of Gold, wrote the following:

Despite the complex obsession it created, gold is wonderfully simple in essence. Its chemical symbol AU derives from aurora, which means ''shining dawn,'' but despite the glamorous suggestion of AU, gold is chemically inert. That explains why the radiance is forever. In Cairo, you'll find a tooth bridge made of gold for an Egyptian 4500 years ago; its condition is good enough to go into your mouth today... Stubborn resistance to oxidation, unusual density, and ready malleability-these simple natural attributes explain all there is to the romance of gold.


Despite its unique properties, gold has not been a good investment. Over the past 100 and 200 years its returns have barely kept up with inflation. Its value has a low correlation with stocks (prices of gold and stocks move independently of each other most of the time), which is a big positive from the portfolio construction perspective, as diversifying with gold can reduce a portfolio's fluctuations (volatility). However, the diversification benefit comes at a large cost: Once added to the portfolio, gold substantially reduces that portfolio's risk-adjusted returns-its dismal returns negate any benefit the portfolio receives from reduced volatility.

One thing about gold, however-it is real! You can hold it and touch it, and see its shine. This tangibility makes it seem impervious to the whims of politics, nature, and time, as opposed to paper assets such as stocks and bonds. Gold's physical attributes attract investors during times of economic uncertainty, and so it serves a purpose in the markets and society-it is a stabilizing influence. It feels safe.

The thinking of the so-called gold bug (a believer in gold's supremacy, a gold aficionado) often takes on a variation of this form: While in the bunker (or any other variance of the ''world falling apart'' scenario), you cannot pay for food with paper-a stock or bond certificate (the overwhelming majority of the time they are actually electronic bytes and bits, anyway). You may do so with real tangible assets, however, such as gold. If this scenario played out (God forbid), it is conceivable that gold could become the de facto currency. In that event, you need to have real gold in a safe or buried in your backyard. The wise gold bug would have managed portfolio risk by also investing in a good arsenal of guns, as the demise of government bonds would likely lead to the end of the rule of law as well. Gold held by your broker or through ownership of gold stocks or exchange-traded funds (ETFs) will not come to the rescue; these bytes and bits are not superior to default-free bytes and bits (i.e., U.S. Treasuries). Canned food may actually be a better store of value in this ''world coming to an end'' scenario.

The ever-increasing complexity and globalization of the financial system, rapid spread of international trade, and the availability of risk-free investment instruments that were not available to investors in previous economic crises may have changed investor behavior during economic doomsday times. Financial instruments such as Federal Deposit Insurance Corporation (FDIC)-insured checking and savings accounts, U.S. Treasury bills, and Treasury inflation-protected securities (TIPS) may challenge gold's status as the safest haven in times of inflationary crisis.

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Excerpted with permission of the publisher John Wiley & Sons, Inc. from Active Value Investing - Making Money in Range Bound Markets Copyright (c) 2007 by Vitaliy Katsenelson. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.

No positions in stocks mentioned.

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