It’s said that social security is the 3rd rail of American politics – anyone willing to touch it is likely to have a “shocking” experience and a short career. These days, gold seems to have the same quality in the financial world. Anyone dumb enough to write about gold is ripe for criticisms from either the “gold bugs” for not being bullish enough or from the “barbarous relic” camp for not being bearish enough. Well, let it never be said that I’m not dumb enough to address a topic . . . wait . . . moving on . . .
What seems to be missing in the gold debate is a focus on what “Au” really is and what place it should have in your portfolio. I would argue that when you undertake any asset allocation decision, whether it be gold, common stock, CMOs, or even art, you have three possible alternatives. You are either making an investment, you are speculating, or you are hedging.
Let’s start with the last – a hedge can be defined as an allocation decision intended to offset potential losses that may be incurred by a companion investment. You are seeking to offset some risk with an inverse asset. With gold, the companion investment is likely trust in the U.S. government. By putting money into gold, you are hedging against the debasement of fiat dollars by an unsustainable monetary policy and an overly aggressive fiscal policy.
Jim Grant, of Grant’s Interest Rate Observer fame, has developed the gold valuation formula one divided by T, where T stands for trust. As trust (in the U.S. government) shrinks, the value of gold rises. Mr. Grant’s formula is tailor made for hedging as it implicitly compares gold to the companion investment.
You have to remember however, that you are hedging something – in the case of gold, exposure to the U.S. government. Any allocation beyond what is needed to offset your risk exposure and you’re no longer hedging. How can you tell if you’re still hedging? The easiest way is to ask yourself if you care about gold’s value. If you’re simply hedging (trying to preserve capital and lock in a value), it shouldn’t matter to you what happens to the price of gold (assuming a perfect hedge – a big assumption I admit). For instance, a farmer who hedges his growing wheat crop by selling a futures contract is unconcerned with the price of wheat. If it rises, the wheat crop in the field rises in value while the futures contract that he shorted drops in value. Vice-versa if the price of wheat declines. If you’re using gold to hedge, the same dynamic should be in effect – you shouldn’t care about the price of gold (of course, when the other half of the hedge is the value of “Trust” in the U.S. government, it can be difficult to see the immediate dollar value of rising trust).
If instead of hedging, you’re buying gold in hopes that it rises in value, you’ve either stepped into an investment or a speculation. Which one is it?
Benjamin Graham, in the seminal value investing book Security Analysis defines the two as:
Bottom line, gold is not an investment. Which means by default, any non-hedge money put into gold is speculation. Now don’t get me wrong – this isn’t necessarily a bad thing. Speculation gets a bad rap – most people think the words speculating and gambling are interchangeable. I for one think you can make an educated speculation. If you look at soybeans, analyze yield trends, look at ending stocks, carryover, and projected demand, you can make an informed speculation. The same can be done with gold – if you’re worried about a further drop in “T” (trust in the U.S. government), it may be worth speculating on the price of gold. However, you need to be honest with yourself. Gold is not an investment – you’re either hedging or you’re speculating.
Now you’re probably wondering why I’m splitting hairs here – speculation, investment, who cares as long as you make money, right? In terms of that old Wall Street phrase: “Do you want to be right or do you want to make money?” (a statement that annoys me both in its trader mentality and assumption that being wrong and making money is still a good investment – meaning lottery winners are truly the world’s greatest investors, right? But, I digress . . .). To delve into why it’s important, let’s look at a quote Warren Buffet made concerning gold on CNBC last spring:
For me and my money, I continue to think the prudent path – the one with greatest potential for long-term compounding – is the “investing” path. Should you disagree, that’s fine. You’ll do well to remember that for some reason I reached out – uninvited no less - and grabbed the third rail of the investing world. If that doesn’t speak volumes about my intelligence, I don’t’ know what does. However, agree or disagree, I just hope we can all be honest about what we’re doing with our assets – be it hedging, speculating, or investing.
Harvest Investor © 2011. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.
What seems to be missing in the gold debate is a focus on what “Au” really is and what place it should have in your portfolio. I would argue that when you undertake any asset allocation decision, whether it be gold, common stock, CMOs, or even art, you have three possible alternatives. You are either making an investment, you are speculating, or you are hedging.
Let’s start with the last – a hedge can be defined as an allocation decision intended to offset potential losses that may be incurred by a companion investment. You are seeking to offset some risk with an inverse asset. With gold, the companion investment is likely trust in the U.S. government. By putting money into gold, you are hedging against the debasement of fiat dollars by an unsustainable monetary policy and an overly aggressive fiscal policy.
Jim Grant, of Grant’s Interest Rate Observer fame, has developed the gold valuation formula one divided by T, where T stands for trust. As trust (in the U.S. government) shrinks, the value of gold rises. Mr. Grant’s formula is tailor made for hedging as it implicitly compares gold to the companion investment.
You have to remember however, that you are hedging something – in the case of gold, exposure to the U.S. government. Any allocation beyond what is needed to offset your risk exposure and you’re no longer hedging. How can you tell if you’re still hedging? The easiest way is to ask yourself if you care about gold’s value. If you’re simply hedging (trying to preserve capital and lock in a value), it shouldn’t matter to you what happens to the price of gold (assuming a perfect hedge – a big assumption I admit). For instance, a farmer who hedges his growing wheat crop by selling a futures contract is unconcerned with the price of wheat. If it rises, the wheat crop in the field rises in value while the futures contract that he shorted drops in value. Vice-versa if the price of wheat declines. If you’re using gold to hedge, the same dynamic should be in effect – you shouldn’t care about the price of gold (of course, when the other half of the hedge is the value of “Trust” in the U.S. government, it can be difficult to see the immediate dollar value of rising trust).
If instead of hedging, you’re buying gold in hopes that it rises in value, you’ve either stepped into an investment or a speculation. Which one is it?
Benjamin Graham, in the seminal value investing book Security Analysis defines the two as:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” [Security Analysis, 1951 edition, Graham & Dodd, pg. 38]I’m going to focus on that “satisfactory return” part concerning gold. Gold itself provides no return. It is a shiny rock. Its only worth is the faith we put in it as a means of storing value. Step outside of the often heated gold debate, and think of another commodity – cotton for instance. Cotton does not promise “a satisfactory return.” A cotton farm may be an investment if it can provide a satisfactory retrun (J.G. Boswell anyone?), but a pound of cotton itself provides no interest, no earnings, no dividend. Hanesbrands may be able to turn cotton into a profitable line of clothing, but again, the investment possibility is Hanesbrands, not the cotton or the clothing.
Bottom line, gold is not an investment. Which means by default, any non-hedge money put into gold is speculation. Now don’t get me wrong – this isn’t necessarily a bad thing. Speculation gets a bad rap – most people think the words speculating and gambling are interchangeable. I for one think you can make an educated speculation. If you look at soybeans, analyze yield trends, look at ending stocks, carryover, and projected demand, you can make an informed speculation. The same can be done with gold – if you’re worried about a further drop in “T” (trust in the U.S. government), it may be worth speculating on the price of gold. However, you need to be honest with yourself. Gold is not an investment – you’re either hedging or you’re speculating.
Now you’re probably wondering why I’m splitting hairs here – speculation, investment, who cares as long as you make money, right? In terms of that old Wall Street phrase: “Do you want to be right or do you want to make money?” (a statement that annoys me both in its trader mentality and assumption that being wrong and making money is still a good investment – meaning lottery winners are truly the world’s greatest investors, right? But, I digress . . .). To delve into why it’s important, let’s look at a quote Warren Buffet made concerning gold on CNBC last spring:
“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”When I peruse these sentences, I glean a few tidbits of knowledge. First, Mr. Buffet is not talking about hedging as there is no mention or even inference about a companion investment. Second, he’s making the comparison between speculation and investment. Which route promises safety of principal and a satisfactory return? Is it speculating in gold, or is it investment in farming operations and oil companies? Which route provides the most balanced risk/reward, a shiny rock or operations that can generate revenue, earnings, cash flow, dividends, and interest?
For me and my money, I continue to think the prudent path – the one with greatest potential for long-term compounding – is the “investing” path. Should you disagree, that’s fine. You’ll do well to remember that for some reason I reached out – uninvited no less - and grabbed the third rail of the investing world. If that doesn’t speak volumes about my intelligence, I don’t’ know what does. However, agree or disagree, I just hope we can all be honest about what we’re doing with our assets – be it hedging, speculating, or investing.
Harvest Investor © 2011. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.
