Gold's Hype May Blind Average Investors To Its Inherent Risk
Henry Clay Webster

Gold May Rise, But Is It Safe?

Now that gold's 10-year bull run is official history, you'd think the buzz about the precious metal's promise might finally buzz off. After all, since 2001 when the price of an ounce of gold hit a 22-year low of $257, it has rallied by more than 400 percent, reaching a new record of $1,383 in early October. But if you've been anywhere in shouting distance of financial news lately, you'll know that the bull calls are far from over.

None other than John Paulson, the hedge fund manager who famously predicted the housing crash, recently predicted that gold will at least reach $2,400 and may go as high as $4,000. Deutsche Bank's Dan Brebner, who Bloomberg called the most accurate gold forecaster of 2010, is predicting spot prices of $1,550 next year, and George Soros made it known earlier this year that he expects gold's bull market to continue. So if top investment gurus are betting on a rise in gold, should you? Let's face it -- such big-time investors don't have your interests in mind, and the risks associated with buying the metal at this point might not fit your investment goals.

If you're like most retail investors, the goal of investing is to afford a retirement, not to become a billionaire. While it might be enticing at times to chase the highest short-term returns -- and a large swath of the investing world believes gold is liable to double or triple over the next few years -- this strategy doesn't compliment your long-term need to preserve capital. Although holding gold as 5 percent or less of your portfolio can be a proper diversification technique, a larger bet is too risky for most investors, says Adam Bold, founder of The Mutual Fund Store and host of the The Mutual Fund Show. "I don't know where gold prices are going to go, but the risk of gold going lower over the next two years, by 25 percent say, is high. I think the big moves in gold have already been made."

But wait, isn't gold a low-risk bet?

Not necessarily, but it is marketed this way by everyone from talk radio hosts to textbook-quoting financial advisors. Gold is a hot commodity right now, not because of its safety, but because many investors see substantial gains ahead. But unlike stocks and bonds, which are supported by actual cash profits and dividends, the price of gold is completely at the mercy of buyers' sentiment. While industry institutions, like the World Gold Council, argue that emerging market demand, industrial demand, and central bank buying are major contributors to gold's rise, speculation is by far the main driver of demand. "At the moment, more than 50 percent of gold is going into investment demand," says Morningstar's Mat Hodge, an expert on Australia's gold mining stocks. According to World Gold Council figures, in 2010's second quarter, investment accounted for 52 percent of demand for gold, and demand among gold ETFs and gold trusts rose by 414 percent compared with the same quarter in 2009.

Unlike jewelry or industrial demand for the metal, which remains somewhat steady, investment demand climbs and falls at a much steeper rate. But as history has taught us -- with the 1980 gold bubble, the dot-com bubble, the Japanese financial bubble, and the recent housing bubble -- when any asset class is overridden with buyers, new information or a change in sentiment can quickly cause a run that quickly destroys the gains of a decade.

That could be especially true if the gold market turns this time because of changes in the way we trade the yellow metal today. Gold bugs praise the rise of gold exchange-traded funds, like the popular $56 billion SPDR Gold Shares, for making gold purchasing more convenient to the average consumer. The downside is that selling the commodity is now much easier and faster. During the 1981 gold crash, when the price of gold fell by 50 percent, most sellers made their decision to sell based on phone calls and daily news reports informing them of the selloff, which lasted from January to March of 1980. Today, up-to-the minute spot prices are available on the internet and multiple business channels would alert investors to new information at a much quicker rate.

In a recent interview on the website Mineweb.com, Chris Eibl, head of trading at Tiberius Asset Management, echoed this feeling: "I personally fear the risk of investors deciding not to buy [gold] on a certain day. A day when people come to the conclusion that [the crisis] has softened out and say we don't actually need to buy gold. On that day you can be pretty sure that gold drops a couple of hundred bucks."

Comments like this point to skepticism about gold's oft-cited virtue as a hedge on inflation. Although many academics believe that gold has kept up with inflation over the long run (the last 200 hundred years), the metal hasn't done so in shorter periods. In the back of gold skeptics' minds, like Chris Eibl, is the fact that, when inflation is factored in, the metal still hasn't regained its 1980 average of $612 more than 30 years later. Many gold analysts are calling for gold to reach this point ($1,622) sometime in 2011. So if gold didn't track inflation for the past 30 years, should you bet it will now?

Consider that when John Paulson stated, according to Businessinsider.com, during a New York University Club speech in mid-September that gold could go as high as $4,000 an ounce, he was not predicting its true worth, but admittedly guessing that the price would "overshoot" inflation. This means that investors like Paulson are actually counting on a bubble. So even if you don't believe in the gold bubble, realize that the market movers are hoping to cash in on one.

Gold bulls will tell you that the Fed's inflationary policy of keeping interest rates low and buying up large amounts of securities from the private sector will continue to send investors into gold as a safe haven. It's common knowledge that "printing money," the common term for the Fed's second stab at quantitative easing, could cause inflation that will devalue the dollar and any assets denominated in dollars, such as stocks. "Everybody always knows that government is spending all this money. That information is already out there. The price moves in advance, not [after the fact]," warns Adam Bold.

At the end of the day, while gold has long been a traditional safe haven, you might not want to get in now. This is especially true if you just have a few more years before retirement. Although U.S. stocks are not popular at the moment because of economic uncertainty, they're relatively cheap compared with expected future earnings. "You've got 150 out of the stocks in the S&P 500 that are yielding more than the 10-year treasury. That hasn't happened since 1958," says Dirk van Dijk, director of research at Zacks Investment Research. "Based on historical risk and potential return, gold just doesn't have the same risk/reward ratio." Like other gold skeptics mentioned here, Dijk thinks that though gold may well be a good investment in the short term, its past record shows that if it drops precipitously, it doesn't necessarily recover quickly. After all, instead of trading sideways for 22 years like gold after its 1980 bubble, following the dot-com bubble in 2000, the S&P 500 regained its highs within 7 years. Even in the market's current uncertainty, the S&P 500 has already rebounded 75 percent from its 2009 low.

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