On the internet, I feel like I come across quite a few people who seem enamored by gold. Not so much the gold itself, but gold as an investment. I personally don’t understand the appeal. I understand the desire to hedge against inflation risk. But is gold really a great inflation hedge? Is it a good investment at all? Other than the fact that Gold has intrinsic value as opposed to fiat money, there’s no reason for gold to appreciate aside from supply and demand issues faster than inflation. Sure, it’s better to hold gold vs cash during an inflationary period, but is it better to hold gold vs. equities as well? My initial gut feeling is no.

First, let’s talk about inflation. I personally think that some people react a bit irrationally towards inflation. Is inflation a bad thing? Yes no doubt about it, inflation is costly and reduces the efficiency of the economy. It’s something the Fed needs to be ever vigilant towards. Beyond just the most obvious “menu” costs (price of printing new price labels), inflation tends disrupt spending decisions in the economy.  The economy functions better when there is price certainty, economic participants are more willing to engage in business dealings knowing that a deal they do today will be priced the same as if it were done tomorrow. It could be argued that steady expected inflation is in itself not bad because if we know it’s 20% every year decisions can be made accordingly. The problem is generally speaking higher inflation rates imply higher inflation volatility. It could be 20% one month and 10% another. When inflation is low (but not deflationary), it stays in a narrow range that is bounded by 0 at one end, and a low percentage like 3% on the other. Inflation also makes holding cash more costly which can further disrupt spending decisions. If a $1 today will be only worth $.50 tomorrow, then I might be inclined to spend that dollar today rather than tomorrow even if I rather spend it tomorrow. This last effect tends to affect the savings rate which has important long term economic consequences. Inflation is also bad because people have negative reaction towards inflation, and they assume the worst, lowering consumer confidence, in turn souring the economy.

So why do I think that people overreact? Inflation creates 2nd order effects; “menu cost”, decision uncertainty, etc., but Inflation in itself means nothing. Inflation is purely a pricing issue of Money itself. Given that we price everything relative to Money, it’s clearly disruptive, but if you take the price of money out the equation other assets should remain inflation agnostic. Even if inflation were high, a cow would still be worth two sheep (or something like that) if I were to barter. So gold should have no more value as an investment than any other asset besides money itself.

So why are so many investors beholden to allure of gold (and to a lesser degree other commodities)? I can only speculate. I think Gold appeals to natural bears. There’s always going to be segment of population who are pessimistic on economic prospects. As there’s always going to be segment of the population that tends to be risk adverse. Some people also think they can outsmart the market. Then there are people who are by nature suspicious of fiat money (traditional gold bugs) who appreciate a currency that has intrinsic worth. At the overlap of these segments, I believe you find today’s gold bugs.

But beyond my biases against gold as an investment, is gold a good investment? Does gold properly hedge against inflation? Mish over global economic trend analysis discusses it much greater detail, but generally concludes that Gold is not much of inflation hedge, though it has may have other financial uses. I think there are many reasons to be concerned about the economy at any given time, and I share many of the same worries now that gold investors have. However, the main difference between me and them is that instead of fleeing towards gold, I know I’m in it for the long haul when it comes to my equity investment. If I think the market is over-extended, I rather buy puts or sell calls than buy gold. I don’t want to imply that there isn’t a place for commodity investment such as Gold in one’s portfolio, but rather that there is no special place for them (other than if you’re really worried and want to hoard gold at home for the day civilization collapses). I invest in equities because ultimately I believe in progress. Eddy Elfelbein has nice chart showing the performance of gold relative to the Wilshire 5000. The stock market is about progress.

Disclaimer: This is not intended to be investment advice, purely the opinion of a haphazard investor on gold.