Going for Gold

You don't have to look far to find someone on TV talking about how gold is a great investment. It seems like at least once a week, CNBC has someone on-air that says gold is going to hit $1,500 or $2,000 an ounce (currently, it's around $1,240). So how do you know if gold is a good investment? By figuring out whether or not other people believe it is.

Why They Love It

For starters, gold is a commodity, so it isn't a traditional investment. A prudent long-term investor buys a stock or bond with the intention that it will provide dividends or coupon payments that would provide a nice return. Investing in gold is purely speculative: you only make money if its price goes up -- it pays no dividends or interest.

And that price will only increase insofar as investors buy more of it, because they believe their other options will do comparably poorly. One driver for gold investing is inflation. Since currency values decline when deep inflation grips a nation, gold might seem like a good place to put your money, since its value can't be debased.

But that doesn't mean gold is the only option here. Platinum should also retain its value fairly well. So should most other commodities that are little affected by other economic shocks. What makes gold so attractive? The fact that it's the first thing people think about investing in when inflation is feared. It's popular, so its price may increase even more than other commodities.

Even stocks can be a good investment as a hedge on inflation. Companies that produce goods and services will raise their prices if inflation becomes a problem. As a result, their stock's nominal values will also increase as their nominal -- not real -- revenues climb with the price level. Your return on those stocks will include an inflation adjustment. The only thing that would make stocks a bad investment during this time is stagflation: when that inflation is accompanied by a recession. Under that circumstance gold is a better investment, since its value likely won't decline as much as stocks or currency.

Is Now the Time?

If you follow the markets, then you know gold has been doing quite well over the past several years. Here's a chart from goldprice.org:

gold_5_year_o_usd 2010-05.png

As you can see, gold has increased by almost 200% in just five years. That averages out to 40% per year. This sort of return isn't sustainable, unless inflation has gotten completely out of control. It hasn't, as it's been only a few percent per year over this time period. But gold's continued rise shows that many investors are still scared of currency and other investment options.

But its future success depends on this mindset growing even stronger. Will investors continue to prefer gold forever? It's hard to see how. As the recovery takes hold, businesses will begin growing again, and investors won't be as scared of stocks. For gold to keep rising, you would need even more investors to flock to gold and sell off their current portfolio of stocks, bonds, currencies, or other commodities. Surely, there's some limit to how many investors can move their money to gold. Nothing can sustain 40% annual returns for too long.

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