Fool's Gold (Part 2)

In part 1 of this article, I laid out some common sense explanations why gold is best utilized for short-term trading. Furthermore, I emphasized that gold rarely provides a good hedge against inflation. When it does, it’s most often a short-term phenomenon. In Part 2 of this series I’ll demonstrate this.

Let’s begin by looking at a gold price chart from 1975 to 2009. Note that gold prices in this chart have NOT been adjusted for inflation.

If you bought gold any time between 1980 and 1998 and held it, you lost out—UNLESS you made a short-term trade, or exited after a couple of years.

Depending on when you bought it, you had to wait until anywhere from between 2004 and 2008 in order to make money (these periods have been roughly estimated, but you can get the general idea by studying the price chart below).

 

Okay so let’s assume you bought gold, held it for several years, and then sold it at a higher price. Did you really make a profit? Chances are, if you held gold for several years, you actually lost money after adjusting for inflation.

Let’s take a look at investors who held gold for 20 years. If you bought gold in 1990 for around $375, you had to wait for the recent gold bubble to make money after adjusting for inflation. But your annual rate of return would have only been around 1 or 2%.

Those who bought gold in 1998 or 2000 have done much better – so far. But they could lose these gains if they fail to cash out before the bubble implodes.

If you bought gold for say $250 in 2000, you’ve done quite well with a buy-and-hold approach, largely because you happened to have bought it just prior to the gold bull market. And because your holding period hasn’t been that long, the effects of inflation are small relative to the price appreciation.

Regardless, the fact is you could have done much better by trading it. Even if you aren’t a great trader there have been a couple of fairly substantial price corrections since the beginning of the gold bull market in 2002.

If you were able to recognize these periods, you could have sold high and reentered low. This would have lowered your cost basis while reducing short-term liquidity risk. These two periods were easy to spot if you understand basic dynamics of asset price movements.

 

But as you can imagine, even this recent spike in the price of gold hasn’t combated the effects of inflation for those who held it for a longer period. So they did NOT make money.

In fact, they may have lost a good deal of money (depending upon how long they held it and what price they paid) due to the effects of inflation. Generally speaking, the longer they held gold, the more they lost.

In the chart below, I demonstrate several scenarios for an investor that bought gold at $400. If this investor happened to buy gold closer to the commencement of the bull market, he or she would have done much better.

When you adjust the price of gold bought any time during this twenty-year period with inflation, you would have lost money if you held it. 

 

Therefore, when it comes to investing in gold, TIME isn’t on your side because the effects of compounding inflation add up. It’s much more important to have good TIMING. This means you need to carefully pick your entry and exit prices, while making sure to keep your investment horizon short enough so that the effects of inflation don’t neutralize any price appreciation.

You might imagine why gold dealers like Kitco and gold bugs never post charts of gold’s REAL value in today’s dollars. The gold-selling business (at least for investment purposes) wouldn’t do so well.

Instead, they show you charts of gold adjusted for inflation, which has no relevance since we are no longer on the gold standard.

Let’s