It's all over the news. The world's financial markets are in turmoil. The eurozone is teetering. The U.S. is heading off a fiscal cliff. Gold bugs are cheering the demise of paper money, and copies of Ayn Rand's epic novel Atlas Shrugged continue to fly off the shelves - both literally and in cyberspace. Is the world really about to end? Do you need to stockpile gold bullion in preparation for a complete financial collapse? Maybe, but probably not. What you do need is an intelligent approach to money management going forward.
The Devil Is In the Details
Gold bugs love to point out examples like Zimbabwe as proof that the U.S.'s only option is to inflate the currency out of existence. It's a romantic notion, especially if you happen to own a lot of gold - or you're a gold dealer. Of course, reality paints a mixed picture of what gold has accomplished in the past.
The unfortunate, and inconvenient truth is that there have been a few times when gold bugs have lost investment battles - and lost in a huge way. Since 1960, there have been four periods during which an investor would have suffered real (adjusted for inflation) investment losses of at least 50 percent by holding gold. You might think that gold has historically made a strong rally during times when democrats held office only to see it retreat when republicans controlled the white house. Not so:
Another common assumption is that gold surges during times of inflation - thus aiding in the perception that gold is a good hedge against inflation. However, the graph shows that 35 of the last 50 years, gold didn't provide any significant protection from inflation. In fact, sometimes, investors actually lost money playing the inflation card.
Ideas Move Markets
Look closely at the graph again. Prior to every gold rally, there was an anticipation of bad economic times or political uncertainty. The growth of big government also signals a rally in gold, while even the mere promise of a reduction in big government sees gold tumble. For example, President Ford promised a return to normalcy rather than an increase in the size of government, and who can forget the republican hero Ronald Reagan?
At the end of the day, ideas are shaping the precious metals industry. Buying gold bullion is, in effect, telegraphing what you think will happen in the future based on the dominant ideas in the country right now. It's not really a reflection of what is happening, but rather what you think will happen. Is the country moving towards statism and a hatred of free markets? Bet on gold and you'll probably do well. Is the country moving towards capitalism? Gold (as an investment) probably just became your biggest financial liability.
Treat Gold as Future Money
Unless the United States (and the rest of the world for that matter) gets serious about adopting capitalism, instead of a mixed economy, it's going to be a slow road to serfdom as Hayek predicted. Along the way, you're going to see some ups and downs in the gold market though and it's going to get very ugly. If you're using gold as an investment, you absolutely must be an all-out expert in the precious metals market. That would put you in perhaps the top 1 percent of all investors - an unlikely scenario. Your other options is to use gold to hedge against future uncertainty while using something else to hedge against the uncertainty of gold in the short to intermediate-term.
Keep It Simple
It's easy to overcomplicate things. People do it all the time. They buy stock options on stocks. They straddle positions that they have no business being in. They leverage up gold trading accounts 20 to 1 in the hopes that a 5 percent move will make them a superstar this year. Unless you're a professional investor, it's probably best to keep things simple. When the U.S. was on a gold standard, banks generally kept a certain percent in reserve. In other words, a bank may have enough gold in its vaults to back 60 percent of its bank notes in circulation. Other banks had 100 percent gold in reserve. The market was pretty tolerant of fractional reserve banking, and you should be too.
Decide on how much of a personal reserve you want. If you're really conservative, for every dollar you hold keep $1 worth of gold. Of course, you can also keep 90, 80, or even 40 percent in reserve. It's not an all-or-nothing proposition. To hedge against your gold position, consider insurance contracts with a high intermediate-term values like 10 or 20-pay dividend-paying whole life policies. Consider short-term fixed-income investments, a basket of commodities other than gold, strong dividend-paying stocks, and real estate. Whatever you do, keep it simple. Indexes typically work better than individual securities for non-professionals. Insurance-based solutions tend to work better than index investing with no "safety net."