Here's Why Gold Is A Safe Investment Despite Record Highs


With gold only few dollars shy of marking another all-time high, it’s appropriate to review the investment and central banking ramifications of gold at $1250/oz.

When approaching gold from the point of view of an investor, the first thing you should ask yourself is whether you think gold prices can rise by enough in the future to at least equal the returns you can lock in on risk-free investments. (I’ll ignore transactions and storage costs for the sake of simplicity.) To be attractive, any risky investment needs to at least promise to do better than the risk-free alternative, and Treasuries are effectively the “gold standard” of risk-free investments, the benchmark against which all risky investments need to be evaluated. (Those who think the U.S. will default on its Treasury obligations may be excused from this class.)

A central bank pursuing a gold standard might ask itself a similar question, but from a different perspective: is today’s interest rate environment sufficient to leave investors indifferent between owning Treasuries or gold?

Investors who buy gold need future gold prices to exceed the hurdle represented by, say, 10-yr Treasury yields. With 10-yr Treasuries trading today at 2.5%, an investment in gold makes sense only if gold prices rise by at least 2.5% per year over the next 10 years. Central bankers following a gold standard are content as long as investors in aggregate can’t decide whether gold will outperform Treasuries, a condition which if met results in relatively stable gold prices, but interest rates that change to offset investors’ changing perceptions of gold’s potential price performance.

This chart shows the historical price of gold in blue, and is plotted with a semi-log scale for the y-axis to facilitate the comparison of annual returns. The slope of the coloured lines represents the hurdle price of gold that an investor at different points of time must expect gold to exceed. Gold is good investment when future prices exceed today’s hurdle rate, and a bad investment if future prices fall below today’s hurdle rate.

From 1970 through 1980, gold beat its hurdle rate almost every year, except for 1975-78. By 1979, investors were so anxious to buy gold, figuring it would have another winning year, that gold prices briefly soared to $850/oz. in early 1980. By this time, however, the Fed had taken a hugely restrictive policy stance, with the result that 10-yr Treasury yields had reached double-digit levels.

With the huge hurdle rates that resulted from tight money, gold investors were by and large extremely disappointed from 1980 through 2001, as gold consistently underperformed Treasuries. Not coincidentally, inflation fell from 14.8% in early 1980 to a mere 1.1% in early 2002.

Since 2002, gold has consistently exceeded its Treasury hurdles, leaving investors emboldened and anxious for more. Unlike the situation in 1980, however, the Fed has done the opposite of tightening, pledging instead to keep interest rates very low for an extended period. That means that the future hurdle rate for gold is so low that it shouldn’t be too hard to beat. Thus, gold prices are still rising, and will probably continue to rise until such time as the Fed decides to change course. I should note here that in real terms, gold is still significantly below its peak price in January ’80 (which I calculate would have been $2370 in today’s dollars), so it’s not unreasonable at all to think that gold could reach $1500 or even $2000.

I have said as much in the past (e.g. that gold is likely to rise further), but have also cautioned that with gold at these levels, it is a very risky investment and not for the faint of heart. As a retired person and a long-term investor, I have decided to eschew any exposure to gold, but a more adventurous speculator would likely find gold attractive. For my part, I think equities hold out the better promise of long-term expected returns.

This guest post was published with permission from Calafia Beach Pundit.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.

Tagged In

gold moneygame-us