Q: I'm a little confused about the what the role of gold in a portfolio is supposed to be. Some people say it is a hedge against economic disaster. On the other hand, it's a commodity, so shouldn't it tend to go up when the economy is strong? In other words, gold can't be for both optimists and pessimists, can it?
A: Gold has slipped a bit lately after a spectacular run over the past ten years, so that leads to a natural question: is this slip a warning sign, or a buying opportunity?
It's a bit difficult to answer that question, because gold prices often seem to become unhinged from reality. Fundamentally, gold is a commodity, but it has fewer industrial applications than many other commodities, so it should be less economically sensitive than things like copper or oil. Of course, gold also has a traditional place as a hedge against economic disaster, but it's difficult to say exactly why that is in a modern economy.
Ultimately, what makes it most difficult to define the role of gold is that it is often driven heavily by speculation. That certainly seems to have been the case over the past decade, with 10 consecutive years of price increases. Remember, when gold prices flatten out, let alone decline, you are back to an asset that generates no earnings and pays no interest. Saddled with that kind of dead money, you'd start to envy even near-zero savings account and money market rates.
Speaking of low interest rates, keep in mind that one impact of near-zero rates is to drive people into other investments. This is especially true when rates are artificially low because of Federal Reserve intervention. When rates are this low, you have to start to be concerned about asset price inflation--and whether those prices can be sustained.
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