The recent wild ride on Wall Street has raised questions in the minds of a lot of people, from central bankers to fund managers and individuals. Stock market volatility and losses almost always bring out the same question — both for individual investors watching over their retirement nest eggs and ordinary households with modest savings: “Should I buy gold?”
It looks like one question but there are actually two embedded in it. The first is whether gold is a good hedge against market volatility. The second, which usually contains a larger emotional content, is whether gold is a good investment in case the stock market tanks completely.
The relationship between gold price volatility and financial market volatility is not an absolutely clear one, but many of the driving forces are the same. Economic variables such as growth rates, employment, inflation, and Gross Domestic Product have a significant impact on gold prices just as they do on stock prices. When these economic data elements move up or down they change our expectations about the future and that different picture affects the price we are willing to pay for a stock, a bond, or a commodity like gold.
In addition to economic data, there are also supply factors that affect gold prices, both directly and by changing our expectations. China’s recent activity in selling off gold reserves, for example, exerted a powerful downward force on gold prices.
The economic theory behind volatility in markets remains incomplete. Research done on the subject at the Federal Reserve Bank of San Francisco, for example, revealed that risk aversion could only explain a small portion of the volatility that roils financial markets, except at unusually high levels of risk aversion.
For individual investors, of course, risk aversion is usually the result of elevated levels of anxiety about the market and it is that anxiety which prompts the search for safe investments, a woven steel nest for your egg.
Any potential investor in gold should remember that it is a commodity. And if you do some research into the qualities that make a successful commodities trader, you will find that they seem to combine the nerve and skill of a Formula 1 driver, the knowledge and focus of a Nobel chemistry laureate, and the raw courage of a mongoose. It is a tough, unforgiving market that often seems even more affected by rumor, crowd-psych, and speculation than the stock and bond markets…if that’s possible.
From an economics perspective, then, an individual’s moving investments from the stock and bond markets into the commodities markets — in order to avoid volatility — would seem to be a questionable strategy. If you are committed to this strategy, though, it would make sense to garner as much knowledge, good advice, and good management as you can.
The second question about gold’s value as a hedge against a financial market crash deserves a separate answer. The anxiety level behind this question is a bona fide investment element that needs to be addressed.
The most important decision that an investor pursuing a crash-absorbing strategy should make is the scenario expected. If your expectation tends toward the apocalyptic, then physical gold would be one element in a broad, survivalist portfolio. If your view of a post-crash environment is a milder sort where stocks and bonds — “paper investments” — are seriously devalued but otherwise unimpaired, then gold as an investment still might have some attraction, depending on how bruised the monetary system is.
Sometimes, details of your expected scenario can be determinants of how much sense it makes. During its dangerous Southeast Asian operations in the 1960s and 1970s, for example, many Air America pilots wore gold bracelets on missions. Gold Rolex watches with expansion bracelets were also popular.
The scenario behind the gold bracelets and watches was that if the aircraft crashed or had to land in hostile territory links could be broken off and traded for food, shelter, or other aid. Of course the gold strategy would only work in scenarios filled with villagers willing to trade instead of violent insurgents who would just take everything.
The basic rule for buying crash-cushioning gold is if it makes you feel better, fits your favorite scenario, and doesn’t eat up all your other options, it’s a valid strategy, particularly if you view it as insurance rather than an investment.
The answer to the original question about buying gold, then, is that there is a place for gold in a diversified portfolio. Its value as a haven from volatility is debatable at best, and its expected value in a post-crash environment may be somewhat unrealistic. If it makes you feel more secure, though, that is the best reason for its modest place in your investment portfolio.
James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.
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