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It seems that the mainstream investment community only
takes a break from ignoring gold to berate it: one of gold’s most
outspoken critics, uber-investor Warren Buffett,
did so recently in his latest shareholder letter. The indictments were familiar;
gold is an inanimate object “incapable of producing anything,” so
any investor holding it instead of stocks is acting out of irrational fear.
How can it be that Buffett, perhaps the most successful
(and definitely the most well-known) investor of our time, believes that gold
has no place in an intelligently allocated investment portfolio?
Perhaps it has something to do with his mentor,
Benjamin Graham.
Graham, author of Security Analysis (1934) and The
Intelligent Investor (1949), is correctly respected as one of
history's most knowledgeable investors. Over a career spanning 1915 to 1956,
he refined his investment theories, in time becoming known as the father of
value investing. Graham’s intellectual framework provides the basis for
many mainstream investment theories today.
According to Graham, while no one can tell the future,
there are periods when the valuations of stocks and bonds would deviate from
fair value by becoming excessively over- or undervalued. To enhance returns
and reduce risk, investors should alter their portfolio allocations
accordingly. A quick look at a long-term chart supports Graham's theory
clearly shows periods when one asset class offered a better value than the
other:
But what of the periods when both stocks and bonds
stagnated or fell together? For much of the 1970s and again from 2001 through
today, any portfolio allocated solely between stocks and bonds would have at
best treaded water and at worst drowned in a sea of stagflation. To earn any
real return, an investor would have needed to seek alternatives.
It’s clear from this next chart that gold was
exactly that alternative, a powerful counter-trend investment for periods
when both stocks and bonds were overvalued. Yet gold is conspicuously absent
from Graham's allocation model.
But this missing asset class is entirely
understandable: for most of Graham's adult life and the most important years
of his career, ownership of more than a small amount of gold was outlawed.
Banned for private ownership by FDR in 1933, it wasn't re-legalized until
late 1974. Graham passed away in 1976; he thus never lived through a period
in which gold was unmistakably a better investment than either stocks or
bonds.
All of which makes us wonder: if Graham had lived to
witness the two great bull markets in precious metals during the last 40
years, would he have updated his allocation models to include gold?
We can never know.
We can know, however, that given Graham's outsized
influence on investment theory, there is little question that his lack of
experience with gold, and therefore its absence from his observations, has
had a profound effect on how most investment professionals view the yellow metal.
This, in our opinion, goes a long way toward explaining the persistently low
esteem in which gold is held by the mainstream investment community. And, as
a consequence, its widespread failure to even be
considered as an asset class.
A couple of takeaways: first, perhaps now you can stop
wondering why your broker, the talking heads in the financial media, and
Warren Buffett continue to misunderstand gold as a portfolio holding. More
importantly, however, is that in order to have sustained, long-term investment
success, one must accept that an intelligent portfolio allocation needs to
include not two but three broad categories of investment –
stocks, bonds and gold, with the amounts allocated to each guided by
relative valuation.
Investors who understand this tenet have an almost
unfair advantage over other investors as it allows them to get positioned in
gold ahead of the crowd and enjoy the bulk of the ride, while others sit on
their hands.
So when you hear commentators ridiculing gold as a
barbarous relic, lamenting that they cannot eat it or smugly asserting that
it produces nothing, rest contently in knowing that they’re operating
with a severe handicap in their own portfolio. Meanwhile, we’ll
prosper, armed with the understanding that gold fulfills a very important and
specific purpose in a portfolio, namely as real money that protects net worth
during periods marked by excessive government debt and currency debasement
such as we are currently experiencing.
Given the powerful influence of Ben Graham and his
disciples, his curse on gold will not go quietly into the night. But it
should.
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