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Why gold is better than cash
From the Archives
Originally published November 21st, 2010
1370 words - Reading time : 3 - 5 minutes
( 8 votes, 4.6/5 ) , 9 commentaries Print article
 
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Keywords :   Fail | Metals X | None | Panic | Paper Money | Precious Metals |

 

 

 

 

The question most often asked of gold bulls is, “At what price will you take your profits?” It is a question that betrays a lack of understanding about why anyone should own gold. Nevertheless, the simple answer must be, “When paper money stops losing its value”. This response should alert anyone who asks this question to the idea that owning fiat cash is the speculative position, not ownership of precious metals.

 

This sums up the problem. Instead of gold, people commonly think of paper money as the only medium of exchange and as a store of value; cash is after all their unit of account. They see the gold price rising when they should be seeing the value of paper money falling.  Because cash is everyone’s unit of account it is wrongly seen as the ultimate risk-free asset. This is also the fund manager’s approach to investment: his investment returns are calculated in paper money, so he cannot account for a superior class of asset.  He is also taught to spread investment risk across a range of inferior asset classes to enhance returns. Therefore the investment manager wrongly assumes that precious metals is one of those inferior asset classes. All modern investment management works on these assumptions.

 

This helps explains why managed portfolios today have very little exposure to precious metals, but there are other reasons. Investment funds in total have grown rapidly since the 1970s on the back of money and credit creation.  This monetary expansion has fuelled both new funds for investment as well as asset prices generally, while gold and related investments became unfashionable in gold’s twenty year bear market between 1980 and 2000. The combination of these two factors reduced precious metals exposure in managed portfolios to very low levels.  Gold was therefore ignored as an asset class when modern portfolio theory evolved in the 1990s, and is simply not considered by the current generation of fund managers.

 

Consequently, investment funds of all types invest in bond markets, stock markets, property assets, securitisations, foreign currencies and to a minor extent general commodities.  From time to time they may have had temporary and speculative exposure to precious metals, but very few fund managers actually understand that gold is the ultimate hedge against cash losing its value.  After all, if you account in paper money, paper money has to be the risk-free position. The understanding that cash is not risk free is left to private individuals not misinformed by modern portfolio practice.

 

The world-wide accumulation of hoarded wealth in the form of gold and silver ingots, coins and jewellery has been growing at an accelerating rate over the last thirty years. This has compromised the central banks who were actively suppressing the price: the result is that large amounts of gold and silver have passed from governments to private individuals. None of this can be properly captured in the statistics, partly because the central banks involved refuse to provide accurate information about their sales, swaps and leases, and partly because the individuals that hoard precious metals do so secretly, and are therefore beyond the scope of meaningful statistics.

 

The reason these individuals hoard precious metals is the basic hypothesis of this article: they will dishoard gold when paper money stops losing its value.  We should therefore consider the extent and speed of this loss.  In 1973 there were US$1,120 of demand deposits plus cash currency for every ounce of gold owned by the US government[i]. Today, including excess reserves held at the Fed and the $600bn to be printed over the next seven months, the figure stands at $26,512[ii]. In 1973 there were twelve times as many dollars as there was gold at the market price, compared with nearly 20 times today, so paper dollars are more overvalued in gold terms today than at the time when the gold price was only $100.

 

The quantity of paper money will continue to grow as the world wrestles with its problems.  As every day passes, one’s worst fears of yesterday materialise.  Governments, driven by social pressures rather than dispassionate economics, are forced into ever-increasing financial rescues; but by far the biggest problem facing them is the seeming inevitability of a full-scale banking collapse.

 

That is what has the panjandrums of Euroland in a panic over Ireland. We are told by the Bank for International Settlements that total Irish debt to foreign investors stands at $791bn, the substantial majority of which is owed by the banking sector. Ireland on its own might not derail European banks, but the domino effect of the spreading problem most probably will.

 

This obviously cannot be allowed to happen. Forget the rights and wrongs of “too big to fail”: politicians and therefore central banks have no option but to intervene.  But what can they do? They cannot fund a rescue with taxes, and they are already borrowing as much as the bond markets can stand.  There is only the nuclear option left, however it is dressed up: shore up the system by printing as much money as it takes. Printing money is simply the way governments buy time.

 

This analysis may turn out to be unfortunately right, or hopefully wrong; but it is more right today than it was last month and also progressively so for the months before that. The rising interest in precious metals is entirely consistent with the growing likelihood that the printing of fiat currencies will continue to accelerate in order to buy off default. While the translation of monetary inflation into price inflation is rarely an even result, we know from both economics and the experience of history that the two are linked as cause and effect respectively. So we can conclude that paper money will continue to lose its value for the foreseeable future.

 

But accelerating price inflation does not just affect cash as an asset class. Bonds, which are commonly the largest component of a conventional portfolio, will lose value faster than cash. Equities will be lucky to keep up with cash values while bond yields rise and the adverse effects of accelerating inflation result in recession. Property will be hit by rising bond yields and rent increases that can only lag inflation. Only commodities, which are a minor asset class for portfolios, can be reasonably expected to outperform cash. Furthermore, equities and property are commonly used as collateral against the very high levels of borrowings in the private sector, which ties their prices to interest rates, and therefore to cash.  Furthermore history confirms that gold and silver are easily the best performers in times of rising inflation[iii].

 

So in the middle of today’s banking and economic crisis, those unfortunates who have delegated the management of their investments to professional fund managers have only bought for themselves the illusion of financial security.  They are almost entirely exposed to cash and assets that are dependant on cash itself, because they own negligible amounts of gold and related investments. This means that systemically, portfolios have become totally dependent on the stability of fiat currencies.

 

This makes gold and silver, not cash, the ultimate risk-free investment class. Paper money may be the medium of exchange and the unit of account, but in these increasingly uncertain times gold and silver are the safest stores of value and will continue to be hoarded, irrespective of price, for as long as these uncertain times continue.

 

So if anyone asks you when you might take your profits in gold and silver, smile sweetly and just say, “When paper money stops losing its value”.

 

[i] See table “Gold backing for 26 major currencies” (page 216 of “You can profit from a monetary crisis” by Harry Browne, published by Macmillan in 1974).

 

[ii] Today’s instantly accessible cash is $6.934 trillion, comprised of deposits held in domestic offices less time deposits of $4.323 trillion, plus non-interest bearing deposits held in foreign offices at $71 bn, figures provided by the FDIC. To these are added currency in circulation of $974bn and excess reserves at the Fed of $966bn, figures obtained from the Fed, together with the QE2 figure of $600bn. Gold held by the Fed is listed at 8,133.5 tonnes.

 

[iii] See the German experience 1918 to 1923.

 

Alasdair McLeod

 

 

 

 

 

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Vox thanks for your caution against trading. Your arguments against trading are logical and justified. I would like to add that the age of the trader/investor and whether he is employed or retired(but working and earning) also matter in the decision to t  Read more
Papli - 11/23/2012 at 11:54 PM GMT
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The article is as salient today as back in 2010, and the conversation it generated is also
worth noting, as Gold has fallen about $400 since then, but the general principle holds true:
Metal is real money.
Will Gold fall to $1,000 as many predict, I don't know, wish I did,
I encourage metal investors to control their outlays through disciplined DCA,
so as not to get get shaken out if the 'Big Dip' materializes.

By the time paper money stops losing its value more than enough would have been lost. Consequently, the purchasing power of gold in real terms would have also suffered a set back inspite of gold's high worth at that time in respective currencies. Since knowing when paper money has stopped losing its worth is impossible to gauge, I feel percentage target based investments in gold be liquidated from time to time for cash. This will compensate for manipulations and unexpected negative turns in gold prices. If gold has breached $1700 today who knows next move will be towards $1600 or $1800.
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Papli... I humbly suggest that everybody will know when 'paper money has lost its worth'. At that time NOBODY will exchange their gold for paper.
Personally I will not sell my gold EVER but I will use it "purchase other assets".
Will permanent backwardation occur in my lifetime? I don't know...if not my kids will get it.
I believe Antal Fekete is correct in his analysis of the gold and silver basis.

Cheers
SW
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SW thanks. It is by coincidence that I wrote the comment exactly a year ago and find the quandry of whether gold will move to $1800 or $1600 remains. While in the interim I have not sold my gold either but had I booked profits and traded in gold my gains could have been easily compounded. The option of sticking to our holdings and possibly adding some more or trading remains open. I still feel we could trade our way to better gains than wait for the day when we could barter our gold to buy our needs. Lets not bother too much for our kids have their own destinies to play with as time goes by. Regards.
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HI Papli. We all trade/invest in different ways.
I trade the Gold Spot price with CFD's and with a modicum of success so I do not need to put my stock at risk.
Further,when I have some spare irredeemable paper thingimajigs I swap them for real money.
I am in no real way concerned about the number of thingamajigs that I have to exchange for the real money.
The reason for that is, whether the price of the real money goes up or down over time I am of the firm belief that I will be able to exchange the real money ( if need be) for things that nobody will accept paper money for.
The good thing is that those things will be being sold off by desperate people who will take any amount of gold or silver, simply to survive.
Like my father in law ( a very streetwise person ) liked to say...'He who has the gold, makes the rules'

Re my kids... Gold..its theirs if i have no use for it before I pass on. If I do use it they will receive the solid assets I buy with it.
As Maclead says above " this makes gold and silver,not cash, the ultimate risk free investment class"
I wish you all the best with your endeavours.
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It is interesting to see how both of you view precious metals ownership. There would seem to be two main reasons. Papil sees it more as a sound investment while S W. tends to stress the insurance policy aspect. Both are valid reasons for owning precious metals. There may come a day in the not too distant future when a third reason emerges. What i am speaking of is the government, in what has become their increasingly intrusive poking about in our financial affairs, deciding to do away with paper money entirely and go electronic. That way they would know what you had spent, where and on what you had spent it as well (and most importantly) if you had paid all of the myriad taxes. Should that day come, the only way to participate in the black market would be with precious metals. It could also have uses in other ways for those who might want to conceal certain of their perfectly legal activities such as cigarette smoking, alcohol and fast food consumption from various authotities.
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Vox, I hundred percent agree with you. The third reason for diversification into precious metals is to duck the evil designs of the politician and bankers to deprive us of our last morsel. Of late back home, there has been a sudden surge to get after the corrupt. Resultantly, it is the small and less corrupt whose financial dealings are being intruded into, while the big fries are members of the enquiry panels probing such corruptions. The other day a banker asked me embarrassing questions before accepting a small amount of cash for deposition in my bank account. The rates of FDRs which appear our saviour having invested our lives hard earned money into them after TDS barely compensate for inflation. With currencies losing their worth world wide, the issue of black and white money is gradually becoming less relevant, if not irrelevant. So those who pride in their WHITE holdings are living in a fools paradise. The answer to this writing on the wall is getting hold of physical gold/silver or both and on priority while they are still available. You could achieve this by going long or by trading. Though I have never traded but had I done so my holdings of gold and silver would have been a few multiples higher. I pray to God to give me the guts to trade from today onwards. Regards.
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Papli, with regard trading, i would urge caution. There are a number of things to consider before deciding if doing so is right for you. Myself, i used to trade, but no more. Now i only accumulate when i can. i had some winning trades, but there were also some that went the other way. In the short term, as you observed, who knows if gold will next go up to $1,800 or down to $1,600. It matters a great deal if you are trading, but not whatsoever if you merely hold gold and operate with the firm conviction that in the long run, it will be worth far more than it is today. Before i used to get bothered when my trading position had a bad day. Now i am happy when gold corrects, for it offers me an opportunity to buy at a discount.

Another consideration might be where you live. Above you noted that the purchasing power of gold may not increase, though its paper price could escalate dramaticly. My own thought is that might be so in those countries that are likely to experience a collapse of confidence in their currencies. i am here thinking of those nations using the euro, yen and yankee doodle; the pound sterling quite possibly as well. However, if you are fortunate enough not to be located in the danger zone, there may well be a 3 month to 5 year window during which your gold will buy you a lot more "stuff" than it will today. However, if you live in the danger zone, you may find that your gold does not buy you quite as much fresh water, rice or gasoline as it currently does, but 10 times more fine art and antiques.

There are other factors to consider also, such as just how much exposure to risk can you safely afford to take? And do you want to do your own buying and selling through a pool, or do you want to go a different route, hoping that you are not placing your funds with the next Jon Corzine?
The former will require more of your time; the latter more of your trust. However, should you decide to just buy and forget about it, you will have more time for some of the more enjoyable things life has to offer and you will never need wonder about the safety of your investment.

Good luck with whatever you decide.
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Vox thanks for your caution against trading. Your arguments against trading are logical and justified. I would like to add that the age of the trader/investor and whether he is employed or retired(but working and earning) also matter in the decision to trade or invest in precious metals or other instruments.
For the sake of convincing myself whether to trade or invest in precious metals, I compared my earnings in gold and silver as at this moment and they stand thus respectively; Day 1.13% and 2.29%, this month 2.38% and 6.64%, since 01 Jan 11.1% and 20.9%, 52 Weeks 2.95% and 6.67%.
The inferences(not conclusions) a lay man can draw from these figures are; investments in gold and silver make sense, my profits over the long run have been less in both metals, that gold in one day has generated almost 40% and silver 35.8% profit these precious metals generated over 52 weeks and that profits in silver todate beat gold over the four periods of investment considered.
With these figures in front of me, I ask myself if it would not be insane not to sell sooner than later and walk in to buy lower again to compound my earnings? If I look at the gains over the 52 week period I may start contemplating, but if I base my decision on the profits earned over the other three periods it makes a lot of logical financial sense to trade. As a trader you commit as an investor you lay back and watch hopefully and at times hopelessly.
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