Article by Joe Wiggins, Director of Research at St. James’s Place
Although it could have easily escaped your attention, as it has received such little fanfare, the price of gold has been rising sharply – recently surpassing $4,000 per ounce. Significant moves in the gold price are fascinating from a behavioural perspective because gold is probably the perfect belief asset – that is an asset which is impossible to value in any reasonable way so it’s worth is entirely dependent on what we think other people believe it to be. This has significant implications for how gold might behave, and how people both talk about it and trade it.
We are currently in the stage of the cycle where many people conjure up reasons for why gold is so attractive because they cannot admit that they mainly like it because its price has gone up a lot. That is not to say that there are not valid reasons why an investor might hold the asset but, as usual, near term performance must bear much of the responsibility.
How should investors think about gold?
Gold is not a better form of money: One of the most common and vociferous arguments from investors who are bullish on the prospects for gold is that it is far superior to standard fiat currencies because it holds its value, whereas the like of the US dollar or sterling lose their purchasing power through time. This view makes very little sense. In a well-functioning and growing economy, a positive level of inflation is desired – it encourages spending and investment – this means currencies should lose value through time. It is a feature not a bug. Yes, a dollar today may buy you less than it did 30 years ago, but I am pretty sure that salaries have changed over that time also, and I am confident people do things with their money – like spend it and invest it.
The merits of owning gold change depend on what question you ask. Is holding gold over the long-term better than putting cash under the mattress? Quite possibly. Is holding gold over the long-term a better option than owning productive, real economic assets (such as company shares)? I am not so sure.
Gold has excellent Lindy properties
Although the ‘debasement’ argument often made about gold is an exceptionally dubious one, gold does benefit from the Lindy effect.(1) This is the idea that the expected life of something that is non-perishable is proportional to its current age. In simple terms this means that the longer something has existed, the longer we assume it will last. (The expected future life of Great Expectations is significantly longer than anything published last week). The concept is named after Lindy’s deli in New York City where it was speculated that a show running for a month on Broadway could be expected to last for another month.
Gold has been used as a store of value for thousands of years. People have believed in it for an extremely long time, which should give us some confidence that people will keep believing in it. This feels somewhat amorphous – but when you don’t have much else to go on it matters.
Belief assets can be extremely volatile
The more assets are based on belief than anything tangible the riskier they are likely to be. Why is this? If an asset is driven by strong fundamental features – let’s say a high-quality bond with a contractual return and fixed maturity – the range of potential outcomes is very narrow. The more speculative the asset, the more it is based on indefinable beliefs, the wider the range of outcomes and the greater the uncertainty.(2)
Assets that have long-term, fundamental value drivers experience a (sometimes light) gravitational pull towards some form of fair value. As belief assets have no fair value the price can vary widely – this can be both incredibly lucrative and, at times, painful. (Belief assets are perfect for bubble formation – there is nothing to hold them back).
"If the price of gold fell to USD 2,000, would it be more or less attractive than it is now?"
Prices for belief assets change because perceptions change. If the gold price were to drop to $2,000 is it more or less attractive than it is now? Nothing will have changed about the yellow metal, just what people believe other people believe about it.
Price moves in gold create stories about gold
As we are being bombarded with stories around the reasons for the rise in gold price – debasement, fiscal largesse, central bank purchases, political uncertainty – it pays to remember the causality here. Price moves come first and then the narratives to justify it second. It is not that the stories have no validity, it is just that they become more persuasive the higher the price rises, creating a self-reinforcing loop – for a time at least.
Do you like the asset or its trend?
Momentum investing has a long and storied history of delivering positive returns – but only if carried out in a deliberate and measured fashion. One of the problems with strongly trending belief assets is that rather than acknowledge that they want to participate in the price momentum, investors need to offer a compelling fundamental rationale. Although this might make them sound smarter, all it means is that they are a closet momentum investor without the discipline required to do it well.
Know why you own it
Perhaps the key for any investor owning gold is to be very clear about why you hold it, otherwise you risk being whipsawed around as price trends (and beliefs) fluctuate. If you purchase it tactically be specific about the precise factors that are informing your view (even if it is just trend following). If it is a structural portfolio holding you should be willing to bear periods of significant losses with equanimity and understand the exact role it is playing.
There is nothing inherently wrong with holding gold, but it is important to accept the type of asset it is and the investment behaviour it may encourage. If Ben Graham had been asked about gold, he may have said something like:
In the short-run, the market (for gold) is a voting machine, and in the long-run it is also a voting machine.
This article was first published on Joe Wiggins' Behavioural Investment blog. We would also like to draw your attention to his book "The Intelligent Fund Investor". The book examines the beliefs and behaviours that lead investors astray and shows how they can make better decisions. You can purchase a copy here.
