Sunday, April 17, 2011

Why Gold is a Good Hedge Against Inflation

Last week, I received a comment about gold/ commodities being an accurate gauge of inflation.  The beginning of the comment was as follows:

"I'm a novice on this, so forgive me if I'm off-base, but your statement that created money goes into hotspots (and the idea of bubbles) seems to conflict with my understanding of commodities.  I thought that commodities were an accurate gauge of inflation, so gold (and oil) going up, would indicate a devalued dollar, not an artificially created 'bubble' in oil (or gold)."

Let me attempt to clear this up.  While gold has a certain correlation with inflation, it is not a direct correlation in the short-term.  If you want an investment as a "hedge" against something, then you want it to react strongly.  For example, TIPS (bonds that adjust for price inflation) are not a good hedge against inflation.  Even if you put half of your portfolio into TIPS and price inflation started raging, then only that one half of your portfolio would stay even with price inflation.  The other half would be vulnerable.  If you want to find a good hedge against severe price inflation, then you need to find something that will go up at a faster rate than the rate of price inflation (in the short-term).

This is where gold comes in.  Just like real estate, gold will have a strong correlation with inflation over long periods of time.  But over shorter time frames, there is not necessarily a strong correlation.  Gold was a terrible investment from 1981 until 2001 and yet there was positive price inflation in every year, although it was relatively low when you compare it to the 1970's.

When you look at the 1970's and you even account that it was during a time when it became legal again for Americans to own gold, you can see that the price of gold went up far in excess of the inflation rate.  If you had put all of your money into gold when it became legal and you held it until 1980 before it crashed, you would have made a profit in real terms.  Adjusted for inflation, you still would have been way ahead.

This is why gold is such a good inflation hedge.  Gold tends to rise and rise dramatically during times of uncertainty and times of high inflation.  It is also a canary in the coal mine when it comes to future price inflation.  When people are worried that the Fed will create a lot of new money out of thin air in the near future, they turn to gold to protect their savings.  In times of high inflation (and we do have high monetary inflation right now), gold will do especially well.  If you have just a quarter of your investments in gold, then it can make up the difference for your other investments that aren't keeping up with inflation.

As for bubbles, I don't think gold is currently in a bubble.  There is no mania yet.  The only mania I see is trying to get people to sell their scrap gold for cash.  In a mania, you would see people trying to come up with cash to buy gold.  While I do think that gold can be a "hotspot" for newly created money, it does not mean that the price of gold is about to come crashing down.  There are logical reasons why gold is going up significantly right now.  People are afraid of the future and afraid of fiat currencies (particularly the U.S. dollar).

In conclusion, during times of unusually high inflation, you should expect gold to go up at a rate that is even greater than the inflation rate.

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