Why Warren Buffett Is Wrong About Gold (IAU, GLD, SGOL)

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March 12, 2012 12:29pm NYSE:GLD NYSE:IAU

Russ Koesterich:  No investment topic elicits as divergent, impassioned, and occasionally violent opinions as gold. Many investors will readily admit to having no strong views on stocks, bonds, or real estate, but gold almost always elicits an opinion.

One of the more vocal and visible proponents of the anti-gold view is  Warren Buffett, who recently reiterated his long held view that gold does not belong in an investment portfolio as it produces no income and has no intrinsic value.  With all due respect to Mr. Buffett, this argument ignores two crucial facts: gold helps to diversify a portfolio and, if only by an historical fluke, it is a recognized store of value.

Diversification is the only “free lunch” available in finance. It is the cosmic loophole to the otherwise unavoidable truism that to produce higher returns you need to take on additional risk.  By combining assets that are uncorrelated, i.e. move in different directions at different times, investors can lower overall portfolio volatility, which in turn can help preserve returns. One of the principal advantages of gold is that it generally has a low correlation with other asset classes, a dynamic that is particularly valuable during periods of rising inflation. As such, even a modest allocation to gold – less than 5% –  has historically raised the risk-adjusted return on a portfolio.

The second argument for gold is that while the metal produces no income, it has historically fulfilled its role as a store of value and an inflation hedge. The argument that gold is an anachronism whose value is purely dependent on the ”greater fool” theory is espoused by many, including Mr. Buffett. The Oracle of Omaha hammers home the point by comparing gold to the infamous Dutch Tulip Bubble.  However, the Tulip Bubble was an idiosyncratic event that occurred centuries ago in one particular part of the world. Gold has been a store of value for millennia. While Mr. Buffett is quite right that gold neither produces income nor has any practical use, several thousand years of economic history have, for better or worse, assigned to gold the role of a default currency.

Today that role is arguably more valuable than ever. The Fed, along with many of the other central banks, is in the midst of an unprecedented monetary experiment: Over the past four years the US monetary base has tripled, while at the same time the United States is no closer to addressing its fiscal deficit. In this environment, inflation may not be an imminent threat, but it is certainly a longer-term risk, one that is made even more real by the fact that today’s bond prices contain little or no inflation premium. As such, even a modest amount of inflation will quickly erode the purchasing power of any fixed-income instrument. Equities are a better inflation hedge, but a portfolio can still benefit from an additional allocation to gold.

Gold should never form the anchor of a portfolio. But in small amounts its serves a purpose; gold helps protects purchasing power over a multi-decade period. For those like Mr. Buffett, who are still unconvinced it is worth remembering that only forty years ago it still took only $50 to buy an ounce of gold.

Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.

Diversification may not protect against market risk.

ETF DN Related Tickers: SPDR Gold Trust (NYSEArca:GLD), iShares Gold Trust (NYSEArca:IAU), ETFS Physical Swiss Gold Shares (NYSEArca:SGOL).

Written By Russ Koesterich From The iShares Blog

Russ  Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm  (originally Barclays  Global Investors) in 2005 as a Senior Portfolio  Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several  research groups focused on quantitative and top down  strategy. Russ began his career at Instinet in New York, where he occupied several  positions in research, including Director of Investment Strategy for  both US and European research. In addition, Russ served as  Chief North  American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008,  Russ published  “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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