Investing in gold – dangers and shortcomings

Gold rush has hit Slovakia in recent months. At least I got the feeling that, despite the mild winter, it feels like being near the Klondike River in Yukon, Canada.

Gold offers have flooded the internet. Obviously, I was not the only one to notice the marketing campaigns of coin and bars dealers, as the number of questions regarding gold sent to Finax has increased.

The gold coin dealers make use of the coronavirus as another argument on why you need to invest in gold. Fear, as one of the strongest human emotions, sells well. It is the uncertainty caused by the pandemic that has created a large breeding ground for the increased interest in gold.

The properties of gold predestine it for attracting money. Nice colour, gloss, durability, good forge ability, high durability, compactness and limited resources make it an ideal precious metal.

Even without the COVID-19 virus, gold gained decent popularity in our region, especially among the elderly. Due to the limited financial history, our parents did not have many options for savings.

In addition to bankbooks and unit linked insurance plans, jewellery represented one of the few alternatives. That is why gold is very familiar to us. Jewellery, as a valuable asset, have been passed down from generation to generation.

I can still remember the times when grandmothers bought their grandchildren gold chains, earrings or charms for graduation or as a birthday gift.

Gold represents a great imaginary value to Slovaks. Although, its market price remains mostly unknown to them, at least its emotional value is extreme. We traditionally associate gold with wealth.

Fortunately, my emotional relationship with gold was distant, and even at a young age, I didn't understand why should a gold chain appeal to me. I did not think of it as an attractive accessory and I always held the view that the money could have been used better.

I have not changed my opinion and my experience with the financial markets only further solidified my attitude. I will share with you my point of view while also presenting the underlying facts. But as the saying goes, to each their own.

Slovak legislation considers physical gold as a commodity. Investment in gold is not a regulated financial product. Its brokering is not subject to any restrictions or requirements. It can literally be sold by anyone and in any way.

For more experienced people, this fact sets the alarm bells ringing and demands caution. The lack of regulation is reflected in a low degree of transparency in the sale of investment gold.

At the same time, it also sets the direction of this blog, which I have divided into three parts. In them I will answer the following questions and topics:

• I do not want to discredit gold, but at the same time, I don't consider it as an ideal investment. It has no place in my portfolio. Why do I hold this view? Why is investing in gold not as great as it seems? Which part of the process of buying gold coins is an incorrect financial decision?
• What are the most common arguments of gold dealers? Are they relevant or are they more often a myth and an attempt to scare people off?
• So, does it make sense for an ordinary person to invest in gold? What ways of investing in gold do I recommend?

Why isn't gold as great of an investment as it seems to many?

Gold is an overrated investment. It can be, without any doubt, described as a value holder and a certain form of money. In the past, this statement was even more true, but it can still be considered as a currency.

It is therefore more similar to cash than to actually earning financial asset. This is the reason for the fundamental disadvantage of investment in gold, the lower appreciation.

Moreover, as I have mentioned already, there are no restrictions on investment in physical gold, since its sale is not controlled by any state authority. The acquisition of coins or bars is therefore often accompanied by extremely high costs, which significantly reduce the return on investment in gold.

Lower yields in comparison to other assets

Gold does not generate any profit or other benefits that would increase its price. Holding gold does not generate any cash flow, nor does it create added value. The long-term appreciation of gold will always be lower than the appreciation of other assets.

This is a cold hard fact that every potential gold investor has to be aware of. In the long run, its zero added value will prevail and will overcome other factors influencing the price of gold such as market moods, liquidity, money growth, geopolitics, etc.

The price of gold is only determined by the market. As demand continues to grow, supply is limited, and this situation is not expected to change in the future, the price of gold on world stock exchanges will rise.

However, it has to be noted that gold is a commodity with market behaviour. An increase in price leads to a decrease in demand and to an increase in supply. The higher price provides opportunity for more expensive mining and new gold mining technologies, which will increase its supply on the market.

The long-term gold appreciation is relatively low, well below stock market returns or the real estate market. The price of gold, in US dollars, has grown by an average of 4.36% per year over the past 105 years.

The above appreciation does not tell the whole story. As seen from the chart, the long-term yield is significantly distorted by the gold standard system that was in force until 1971.

During that time, there were no free-floating exchange rates for currency pairs, but the gold was the basis for the U.S. dollar and other currencies were pegged to the U.S. dollar's value.

After the fall of the so-called Bretton Woods monetary system, exchange rates and gold prices were eased. This change led to rise of indebtedness and loosened monetary policies, from which gold began to profit.

The development of the price of gold is different for every horizon, as the 105-year chart shows. History remembers periods, when investing in gold achieved very high returns, but also long periods in which the price of gold stagnated or even declined.

The following chart compares the development of the price of gold in euros and the modelled development of two Finax's portfolios, namely the most dynamic 100% equity strategy and the most conservative 100% bond strategy. The comparison dates back to the beginning of 1988, as we have modelled our portfolios up until this date.

Note: All data related to the historical development of Finax portfolios have been modelled and were created on the basis of past-modelling of the data. The method of modelling historical performance is described in the article How do we model the historical development of Finax portfolios. Past performance is no guarantee of future returns and your investment may result in a loss. Find out what risks you are taking when investing.

The development perfectly illustrates the lower appreciation of gold compared to other asset classes. While the price of the precious metal had risen by 326% in almost 32.5 years, the yield, achieved by stocks, is more than four times higher. All modelled Finax data take into account a portfolio management fee (1.2% p.a.).

It is also interesting to have a look at the comparison with the bond portfolio, with the total yield only 21 percentage points lower than the yield of gold. This portfolio mainly consists of government bonds, that are considered to be the safest securities in the world.

This is also underlined by the small fluctuation (volatility) of this portfolio. The bond strategy curve is significantly smoother compared to both stocks and gold. It can be stated that the bonds have offered, in the past three decades, a similar yield, but at a significantly lower risk.

High costs of retail investments in physical gold

In this section, I will talk more about the interesting part of buying gold coins and bars, namely the fees.

The costs of investing in gold are diverse, from the entry fee to higher selling prices compared to gold stock prices, lower buy back prices or various premiums and fees for transportation and storage.

There are numerous types of potential fees and the description of various billing methods would require several blogs.

In general, the greater the volume of gold you buy, the lower the ratio of costs to the value of investment will be. Likewise, the higher the number of intermediaries between you and the gold bars manufacturer is, the higher the final purchase price of your gold will be.

However, there is a problem with buying gold through intermediaries, which I think not many people realize and only few will make the effort to calculate the price actually paid per ounce of gold.

In the case of dealers, who clearly calculate the fees as a percentage or an absolute number, the buyer will relatively easily find the total cost of the investment.

However, gold dealers have discovered that "no fees” sell well. Therefore, their price list does not include standard fees, but they will earn their commission on a significantly higher selling price of gold compared to its market price.

The price of gold in retail sales is given in euros per gram, while on world stock exchanges, gold is traded in US dollars and the unit of weight is the troy ounce.

How many retail investors will do their homework and convert the purchase price of investment gold into dollars per troy ounce in order to be able to compare it with the stock market price?

A troy ounce equals to 31.1034768 grams. In addition to the unit of weight, you must take into account the exchange rate of the US dollar against the euro in the calculation.

Gold price per troy ounce (USD) = gold price per gram (EUR) * 31.1 / EURUSD exchange rate.

I did the math for you. As of June 12, 2020, according to the closing prices of gold and the exchange rate of euro to dollar, a gram of gold cost 49.44 euros.

Let's see what the price of Slovak dealers for a gram of gold was the following day 15.6, according to prices published on the dealers’ websites. The table also contains a column that shows how much higher the selling price is compared to the stock exchange price of gold, i.e. what the margin is between the dealer and the manufacturer.

Investing in gold in small volumes suddenly does not seem so attractive. 20% fee is discouraging. Nevertheless, there are still people, who willingly donate one-fifth of the investment to the dealer. In the case of a 600-euro investment, we are talking about a fee of 110 euros.

With an average historical appreciation of gold, a high margin means that the investor reaches the purchase price, i.e. "zero", in the fifth year of holding the precious metal. Only then, does the investment actually start to make money and appreciate in value.

As I previously mentioned, costs decrease with larger purchases, but we are still talking about fees of around 5%, unless the investor buys gold coins or bars directly from the manufacturer.

On the other hand, gold investment offers good liquidity. Unlike its sale, gold production is regulated, so you will always come across standard coins or bars (e.g. the Vienna Philharmonic). These are relatively easy to sell.

Since it is physical gold, you need to meet up with the dealer or travel abroad. Ask prices may vary. However, most companies buy back gold without margin, as they have already included it in the selling price and at the same time, they sell the gold further.

As the two basic components of investment have shown, namely yield and its costs, the probability that you will appreciate your savings with gold is low.

The most common arguments of gold dealers - myths or facts?

Gold does not depreciate in value - myth

Ask gold investor how much they earned in 2010 and how long it took them to recover. 10 years is the answer! Many have still not managed to fully recover, if we take into account dollar and not euro investors, who have profited from the strengthening of the dollar in recent years.

Or ask investors who have bought gold in 1980 if they managed to hold it for 27 years. That is how long it took their investment to recover from losses and to at least reach its prior value.

Gold will earn you more than other assets - myth

In my experience, gold dealers are very fond of its 20-year appreciation, which they are willing to compare with stock market yields over this horizon. 

However, this data is exactly tailored to their needs. The past two decades are one of the few periods, during which you would earn more on gold than on stocks. Indeed, gold yield was twice as high as the yields of global stocks.

The beginning of this period dates exactly to the peak of the so-called Internet bubble in 2000 and it also includes two major crises and drops in the stock markets.

However, the vast majority of periods, throughout the history of financial markets, show the exact opposite. As I have mentioned already, stocks earn more and the following table also confirms this statement.

It compares the gold yield in euros up until the end of May of this year and the performance of Finax's modelled 100% equity portfolio and the modelled 100% bond portfolio, including full portfolio management fees.

Hyperinflation awaits and gold will be able to protect you from it – myth

It is true, as is often mentioned in regard to gold, that a 100-year gold performance of more than 4% p.a. roughly goes hand in hand with the rise in consumer prices in the US. But, as the previous paragraphs show, the asset that earns the most in the long run will provide the best protection against inflation.

Stocks represent a far better means of protection against higher prices in the economy than gold. They are also physical assets, while also being the best tool for defeating inflation in the long run.

There is no clear correlation between the price of gold and inflation in the United States. These two quantities are not downright strongly positively correlated.

Gold has somehow distanced itself from inflation, and its price has been falling despite the ever-increasing prices of goods and services in the US economy.

Real losses, taking inflation into account, have not been recovered by gold since 1980. Incredible 40 years have passed and you still have not really earned anything on your investment in gold - the rise in the price of gold did not even cover inflation. Gold would, therefore, not protect you from rising prices.

The second part of the statement is the foreshadowing of hyperinflation. Hyperinflation is a rise in prices in the tens, hundreds, or even thousands of percent per year. According to gold dealers, but also some economists, the reason for this increase is supposed to be money-printing by central banks.

In the economy, nothing can be ruled out for good, but deciding where to put our savings on the basis of constant catastrophic scenarios will only result in you depriving yourself of money. The basic scenario will always be a positive development, even though nothing is perfect and we will never get rid of human excesses in the form of e.g. bubbles.

We were expecting hyperinflation already after 2008, when central banks saved the financial system with massive stimuli. The result was supposed to be an extreme rise in prices, from which gold benefited between the years 2008 and 2010. However, inflation did not arrive and the precious metal lost more than a third of its value in the following years and has not yet managed to reach its past peaks.

Anyone who follows the latest economic events in the world knows that decrease in prices remains a more pressing problem in advanced economies. Deflation is a much less desirable phenomenon for monetary policy makers. In addition to low economic expansion, price growth in the economy is hampered by stagnation in productivity, high indebtedness, automation, and innovation in general.

Every economic crisis, including the current one, has a deflationary effect, thus leading to decrease in prices. Total income in economies is declining, which reduces demand and, of course, prices in the economy. So, we will be lucky if there is any inflation at all in the short term.

Gold will protect you from the crisis and stock market declines

Even this statement is only a half-truth. Historically, gold has generally risen, when markets declined or at least maintained its value. But this is not always the case and should not be relied upon every time.

At a time of economy adjustment and decline in value of other assets, people do not have much money left to pour into gold. Every extra euro or dollar prefers to stay in government bonds or cash in order to take advantage of falling prices of the assets that are more attractive in the long-term.

The importance of bonds can be easily confirmed. You only need to look at this year’s development of gold and US government bonds.

The following two charts compare the development of the two iShares ETFs in USD from the beginning of the year until June 12, 2020. The former invests in physical gold bars and rods (IAUs) and the latter invests in US government bonds with a maturity of 10 to 20 years (TLH).

Gold rose by 13.7% this year, while bonds by 16.1% (dollar). The bonds performed their task better and thus confirmed their role in portfolios requiring lower risk.

Gold has lower volatility (price fluctuation) than other assets

This marketing argument can be once again verified by real data. I compared the volatility (standard deviation or variance) of annual gold yields with Finax's modelled equity and bond portfolios over the past 32 years.

Gold does indeed have a lower volatility (price fluctuations) than stocks. If we have a look at the annual volatility, the difference is less than two percentage points, which surprised me, as I expected a lower one. Bond volatility is significantly lower than the volatility of other assets.

The three basic asset classes can be ranked according to the degree of risk taken from the smallest to the largest as follows: bonds, gold and stocks.

However, the risk itself tells only half the story about the quality of the investment tool. The other side of the equation is the achieved yield. This side is clearly dominated by stocks with a decent lead on gold, behind which is the bond appreciation.

Precisely for the objective consideration of both key parameters of the quality of investment, the Nobel Prize laureate William Sharpe developed a basic ratio indicator, which also bears his name.

Sharpe ratio creates a simple ratio of return and volatility, which depicts the return achieved per unit of risk taken. The higher the ratio, the better the investment, i.e. it generates the highest return on the risk taken.

I do not recommend using only the Sharpe's ratio when choosing an investment, as you would generally prefer conservative investments. It is always necessary to take into account the expected return of yours as well as the investment horizon. Time eliminates market risk.

Widely used indicators of the quality of investments in the financial world have confirmed that gold is quite far from an ideal investment. According to Sharpe ratio, gold is clearly the worst investment among the basic asset classes.

Should I invest in gold? How much and in what way?

Gold has a stable place in the world and in investment portfolios. Its popularity will certainly not diminish, it will constantly accompany us and its value will grow.

Likewise, gold is likely to benefit from the current situation in the world for some time. Central banks are pouring a lot of liquidity into the markets and the economy is in recession with a gradual recovery expecting to happen, which should be a favourable environment for the demand for gold.

However, investing in gold does not make sense for retail investors. It resembles speculation rather than investing. The facts speak clearly against gold.

Long-term returns are low, the risk is still relatively high, the investment tends to be too expensive, and holding physical gold brings many complications and non-financial risks (e.g. theft).

I consider the biggest advantage of gold to be the low correlation of its price with other assets. Gold does not adhere to the standard fundamentals as stocks and bonds do. As a result, it can be used as a tool for portfolio diversification, since it reduces its volatility.

Personally, I have a vast experience with investing in gold and commodities in general. Although I did not have an emotional relationship with it, I was convinced by the arguments of supporters of gold. Early in my investment career, I was a big fan of it, mainly because of the money-printing by the Fed (US Federal Reserve System).

I started working for a broker in the second half of 2007, at the peak of the markets before the great financial crisis, which marked the beginning of my investment career. Paradoxically, it started on a negative note.

I was convinced that the endless liquidity supplied to the markets would lead to inflation and devalue the money to such extent that the only winner would end up being gold.

But gold resulted in losses for me and my clients, while investors, that followed traditional investment rules, made massive profits from stocks, despite all the negatives in the world. I left the gold not earning anything.

Do not start with the roof when building a house

Gold is clearly only advantageous in larger volumes. Including it in the portfolio makes sense for people with large assets. I am talking about assets in the amount of several hundreds of thousands of euros.

If you manage to build up assets worth half a million euros or more in real estate ownership, entrepreneurship and in the ownership of stocks and bonds, you can start thinking about buying investment gold.

Even in this case, I recommend having only 10% of your assets in gold, as long as the beautiful metal will boost your mood. Feel free to reduce volatility, but also the return on your portfolio, by buying a gold bar worth 50,000 euros. Prefer buying directly from a gold manufacturer. This will save you a lot of money. 

If you have not reached the stage of life that your assets are worth hundreds of thousands of euros, forget about gold. There is no reason for you to place your savings in the precious metals.

Remember the 40-year loss on gold. 40 years is an extremely long period of time, which represents the whole active career of most people. To devalue the savings, for such a long time, is a huge mistake.

Build a house from the ground up. First, build a solid foundation and the walls of your financial house in the form of sufficient emergency fund and financial assets that take into account your medium- and long-term goals such as retirement, housing, financial security and other sources of income.

So far, no more effective long-term asset appreciation solution has been found than a portfolio properly created using bond and equity ETFs. Especially in Slovakia, where returns becomes tax-exempt after a year of holding ETFs.