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Gold and Your Portfolio

Gold and Your Portfolio

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Published by: api-26324170 on Oct 16, 2009
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Gold and Your Portfolio
WSJ says gold is a lousy investment. That might very well turnout to be the case, but the articlehas nothing useful to convince you about that. In fact, its so poorly researched. For example,consider this:
What drives gold prices? It's an alchemist's mixture of fundamentals and fantasy. Gold certainly has industrial uses and it's a hot item for purchasers of jewelry, especially inIndia. But fundamentals don't support the soaring gold picture of late. As Carl Weinberg,chief economist at High Frequency Economics, a Valhalla, N.Y., research firm, notes:"Industrial demand for gold surely is depressed -- along with demand for other industrial materials -- and jewelry demand must be hard-hit by global recession." 
One would think he is bringing up the ‘hot item’ in India part to draw a connection to thedemand, but he ignores it in the next sentence and goes on to talk about industrial demand. Itssad that an article that talks about gold says nothing about the price of gold being driven up byfears of depreciation of the fiat currency (USD).I can think of two questions that are important to the average investor saving for retirement:1.How does gold compare with other assets? The reason that question is important is tounderstand if it has a place in your overall portfolio. It would be silly to sink your entire wealthinto gold or for that matter any one asset class.2.Does
know what the difference is between
? For instance at10,000 is Dow a fantasy or is it based on fundamentals?To answer question 2, I've reproduced Prof Robert Shiller's graph. Do those stock prices looklike they are reflecting fundamentals - i.e earnings?
1870 1890 1910 1930 1950 1970 1990 2010
   R  e  a   l   S   &   P   C  o  m  p  o  s   i   t  e   E  a  r  n   i  n  g  s   R  e  a   l   S   &   P   5   0   0   S   t  o  c   k   P  r   i  c  e   I  n   d  e  x
Year PriceEarnings 
My point is that asset prices are affected by:1.Actual fundamentals2.Perceptions of actual fundamentals and future expectations of fundamentals, and3.Supply/Demand. It doesn't matter if supply/demand is driven by fact or fantasy - in fact itshard to reliably say which it is, which is why history is among the best guides you have. By nomeans is it the only one.
In any case, let's take a look at gold and compare it to stocks. The following chart shows growthof $1 invested in gold and stocks. CPI is the proxy for inflation.
Feb 1970
Aug 1975
Feb 1981
Aug 1986
Feb 1992
Aug 1997
Feb 2003
Aug 2008
        1        0
        1        5
        2        0
        2        5
S&P Total Return
      V     a      l    u     e
Gold, Inflation and Stocks
So what are the annual returns - nominal and real?GoldCPIS&P
Nom. Return8.84%4.48%7.25%
Std Dev19.92%1.17%15.58%Sharpe Ratio44.40% 46.53%
Real. Return4.19%
 Stocks are marginally better in the long run (in terms of volatility and sharpe ratio), but in realterms gold is much better. The higher volatility of gold is only to be expected - its a commodityand most commodities are volatile because they are real assets with no cash flows. The onlything that determines their prices is supply and demand.Sure, history may not repeat itself, but it does say something about which of these assets hasoffered better inflation protection in the past!

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