What is gold’s role in the investment portfolio?


The ‘Who, What, When, Where, Why and How’ of Gold Investment
How to protect and build your wealth through precious metals ownership

In the second entry to our six-part series – What is gold’s role in the investment portfolio? – we examine gold’s performance under the four most commonly predicted worst-case economic scenarios: a 1930s-style deflation, chronic Japanese-style disinflation, a 1970s-style runaway stagflation, and a Weimar-style hyperinflation. For the prudent investor, gold is now, as it has been through the ages, an investment for all seasons.


Who invests in gold?

What is gold’s role in the investment portfolio?

When is the best time to invest in gold?

Where to invest in gold?

Why invest in gold?

How to invest in gold? 

Reader note: This is the second installment in our six-part series on private gold investment. You will receive one additional installment per day in the order listed above. Each installment is designed to shed light on a specific, baseline area of concern for most investors. In each instance, we draw on our many years of experience in the gold business to focus on what matters most to first-time investors – the means to protecting and building wealth for the long-term future.


What is gold’s role in the investment portfolio?

“The inability to predict outliers implies the inability to predict the course of history. . .But we act as though we are able to predict historical events, or, even worse, as if we are able to change the course of history. We produce thirty-year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer — our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.” – Nicholas Taleb, The Black Swan — The Impact of the Highly Improbable, 2010

“That men do not learn very much from the lessons of history is the most important of all the lessons of history.” – Aldous Huxley

Gold as a deflation hedge
(United States, 1929-1945)

The Great Depression of the 1930s serves as a workable example of the degree to which gold protects its owners under deflationary circumstances in a gold-standard economy. First, because the price of gold was fixed at $20.67 per ounce, it gained purchasing power as the general price level fell. In 1934, when the U.S. government raised the price of gold to $35 per ounce in an effort to reflate the economy through a formal devaluation of the dollar, gold gained even more purchasing power.* The accompanying graph illustrates those gains, as well as the gap between consumer prices and the gold price.

How gold might react in a deflation under today’s fiat money system is a more complicated scenario. Even deflation under a fiat money system, the general price level would be falling by definition. How governments treat gold under a deflationary scenario will play heavily into its performance:

– If gold is subjected to official price controls, as it was in the 1930’s deflation, it would likely perform as it did then, i.e., its purchasing power would increase as the price level fell.

– If not subjected to price controls, it would turn out to be the best of all possible worlds for gold owners. Its purchasing power would increase as the price level fell, and the price itself could rise as a result of increased demand from investors hedging systemic risks and financial market instability.

*President Franklin D. Roosevelt also seized gold bullion by executive order in concert with the devaluation, but exempted “rare and unusual” gold coins which later were defined by regulation simply as items minted before 1933. As a result, only those citizens who owned gold coins dated before 1933 were able to reap the benefit of the higher fixed prices. For investors concerned with capital controls including the possibility of a gold seizure, we recommend adding low-premium historic, pre-1933 gold coins as part of the portfolio mix. This recommendation is covered in more detail in the final segment of this review – How to Invest in Gold.

Gold as a disinflation hedge
(United States, 2007-2013)

Up until the “double oughts,” the manual on gold read that it performed well under inflationary and deflationary circumstances, but not much else. However, as the decade of asset bubbles, financial institution failures, and global systemic and sovereign debt risk progressed, gold marched to higher ground one year after another. As events unfolded, it became increasingly clear that the metal was capable of delivering the goods under disinflationary circumstances as well.

The fact of the matter is that during the 2000s, even as the inflation rate hovered in the low single digits (indicated on the chart by the blue line at the bottom of the chart), gold rose from just under $300 per ounce in the early 2000s to just over $1900 per ounce by 2011 – a gain of over 600%. All in all, as the graph immediately below demonstrates, the first decade of the 21st century ushered in a new era for gold, one in which it filled a hole in its resume. Now gold has come to be viewed as an effective hedge against one of contemporary economies’ most nettlesome problems – chronic disinflation and the systemic financial risks it periodically imposes.

Gold as a hyperinflation hedge
(Germany, 1919-1924)

The German citizen/investor who put away a few rolls of 20 mark gold coins in 1918 would have done so at 119 marks per ounce. By early 1920 the previous rapid inflation had suddenly given way to deflation. Had that gold owner decided to cash in on gold’s significant gains thinking runaway inflation was over, a 100,000 mark investment would have made him or her a millionaire.

The glow, however, would have quickly worn off. By late 1921 the runaway inflation had resurfaced but now with a vengeance. Gold shot to 4,000 marks per ounce. By mid-1922 gold reached 10,000 marks per ounce and the wholesale price index went from 13 to 70. By late 1922, the roof caved in. Gold traded at 134,000 marks per ounce. In January, 1923, it cracked 1,000,000 marks per ounce. By midyear, it broke the 100 million marks per ounce barrier and at the peak of the hyper-inflationary breakdown, it sold for over 100 billion marks per ounce.

Most Americans take the attitude that “it can’t happen here”, but the truth of the matter is that no economy or monetary system is immune to the ultimate effects of printing too much money. “Like previous hyperinflations throughout time,” says Patrick Barron, an economics professor at Wisconsin University’s Graduate School of Banking in a paper published at the Ludwig von Mises Institute, “the actions that produce an American hyperinflation will be seen as necessary, proper, patriotic, and ethical; just as they were seen by the monetary authorities in Weimar Germany and modern Zimbabwe. Neither the German nor the Zimbabwean monetary authorities were willing to admit that there was any alternative to their inflationist policies. The same will happen in America.”

Gold as a runaway stagflation hedge
(United States, 1970s)

The word “stagflation” is a combination of the words “stagnation” and “inflation.” President Ronald Reagan famously added unemployment and inflation together in describing the economy of the 1970s and called it the Misery Index. As the Misery Index moved higher throughout the decade so did the price of gold, as shown in the graph immediately below. At a glance, the chart tells the story of gold as a runaway inflation/stagflation hedge.

The Misery Index more than tripled in that ten-year period, but gold rose by nearly 16 times. Some of that rise is attributed to pent-up pressure resulting from many years of price suppression during the gold standard years when gold was fixed by government mandate. Even after accounting for the fixed price, though, it would be difficult to argue that gold did not respond readily and directly to the Misery Index during the stagflationary 1970s.

In a certain sense, the U. S. experience in the 1970s was the first of the runaway stagflationary breakdowns, following President Nixon’s abandonment of the gold standard in 1971. Following the 1970’s U.S. experience, similar situations cropped up from time to time in other nation-states. Argentina (late 1990s) comes to mind, as does the Asian Contagion (1997), and Mexico (1994). In each instance, as the Misery Index rose, the investor who took shelter in gold preserved his or her assets as the crisis moved from one stage to the next.

Gold as the portfolio choice for all seasons

History shows that gold, better than any other asset, protects the portfolio against the range of ultra-negative economic scenarios, such so-called black swan, or outlier, events as deflation, chronic disinflation, runaway stagflation or hyperinflation. Please note that I was careful not to favor one scenario over the other throughout this essay. The argument as to which of these maladies is most likely to strike the economy next is purely academic with respect to gold ownership. A solid hedge in gold protects against all of the disorders just outlined and no matter in which order they arrive. I would like to close with two thoughtful justifications for gold ownership – one from a UK parliamentarian, Sir Peter Tapsell and the other from journalist, Matthew Hart.

“The whole point about gold, and the quality that makes it so special and almost mystical in its appeal, is that it is universal, eternal and almost indestructible. The Minister will agree that it is also beautiful. The most enduring brand slogan of all time is, ‘As good as gold.’ The scientists can clone sheep, and may soon be able to clone humans, but they are still a long way from being able to clone gold, although they have been trying to do so for 10,000 years. The Chancellor [Gordon Brown] may think that he has discovered a new Labour version of the alchemist’s stone, but his dollars, yen and euros will not always glitter in a storm and they will never be mistaken for gold.” – Sir Peter Tapsell, address to Parliament, 1999

“An ounce of gold cost $271 in 2001. Ten years later it reached $1,896—an increase of almost 700 percent. On the way, it passed through some of the stormiest periods of recent history, when banks collapsed and currencies shivered. The gold price fed on these calamities. In a way, it came to stand for them: it was the re-discovered idol at a time when other gods were falling in a heap of subprime mortgages and credit default swaps and derivative products too complicated to even understand. Against these, gold shone with the placid certainty of received tradition. Honored through the ages, the standard of wealth, the original money, the safe haven. The value of gold was axiomatic. This view depends on a concept of gold as unchanging and unchanged—nature’s hard asset.” – Matthew Hart, Vanity Fair, November, 2013


Next, in the third entry to this six-part series – When is the best time to invest in gold? – we address the all-important issue of timing your purchases.


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