How much gold should you have in your portfolio...?
DR. STEVEN CUNNINGHAM is director of research and education at the American Institute for Economic Research (AIER).
In this interview with Hard Assets Investor, Steven Cunningham discusses the changing role of He recently sat down with HAI and discussed gold's changing role in the investment world.
Hard Assets Investor: AIER has been an advocate of Gold for some time now, no?
Steve Cunningham: The founder of the AIER, Colonel Harwood, was a professor at the Massachusetts Institute of Technology. In 1928 he predicted the economic and financial crisis that became the Great Depression. That gave him some credibility and his understanding of the economy and financial markets.
Harwood recognized the value of gold and other metals and made recommendations accordingly. We have a long history of involvement with assets like gold.
HAI: One of the interesting things about the role of gold and monetary policy has been how dramatically that has shifted just in our lifetimes. We've seen gold go in and out of favor as a secondary currency.
Now, we have plenty of commentators saying that gold has ceased to be that store of wealth and has become just another risky asset. Would you agree with that, or would you disagree with that?
Steve Cunningham: I agree that gold has come to be viewed a little bit more differently in the economy than it once was. Gold demand is not driven by industrial demand. It's still driven by individuals and investors. So it can be somewhat volatile.
Gold as an investment vehicle is different from gold as a basis for a monetary system. That's certainly true. Once you disengage it from the monetary system, then of course it's going to gain more volatility.
Gold works well as an anchor to monetary policy, but only when there's responsible monetary policy in conjunction with it. It isn't enough just to have gold as an anchor to monetary policy. There still has to be some responsible policy. It takes both.
HAI: And certainly in the US we don't actually have any direct, official monetary policy relationship with gold anymore...
Steve Cunningham: That's right we don't. There are assets held by the Federal Reserve against currency, but there are no direct links to gold. And there have been proposals for gold standard. There have been proposals for commodity standards. I remember former US Treasury secretary Donald Regan in the Reagan administration talked about using a basket of commodities as a basis for monetary policy.
But I haven't seen anybody really take these things so seriously. Although with the problems we've had recently, I think there's a little bit more interest.
HAI: We had Dennis Gartman on our site a little while ago talking about gold's role as reserve currency. In the absence of any nation state really adopting gold, do you feel that the industrial complex can do that on its own without government intervention?
Steve Cunningham: I find it very hard to see. I get the spirit of it — there's something to be argued about there. But I think the core of money is trust. There has to be the sense of a mutual contract that we're all going to accept this money, say for goods and services, with the understanding that if we accept the money for goods of a certain value, that we expect to be able to buy things later of a similar value.
There's a social element to money. And in order to enforce any sense of universality, you've got to have some sort of generalized agreement. Usually that only comes through some sort of arrangements between governments.
So I just don't see the industrial complex being able to pull this off independently until there is that sort of buy-in from governments. I'm afraid that Gold Prices will continue to be relatively volatile, which would make gold's use in the private sector separate from the government as a source of money problematic.
HAI: To what extent do you think that volatility represents the presence of these new ways to access gold, like ETFs. Do you feel they have changed the nature of gold?
Steve Cunningham: Oh definitely. There are just so many transaction costs associated with dealing in physical gold. With ETFs, it becomes easy to move in and out of gold very freely, just like you would in and out of stocks. And this has opened up the market to people who previously wouldn't have gone there.
It also put gold into portfolios with other securities. For example, we have seen an increased correlation with gold and securities. In the past we looked at gold in portfolios as a way to offset risk and diversify.
But since the invention of these ETFs, we've seen a growing correlation with other assets. For example, in the first couple of months of 2011, SPDR gold shares (GLD) saw net outflows of $2.4 billion Dollars, which is significant. If you're looking at something on the order of $50-60 billion Dollars in total assets, that's enough to start to affect pricing. And we think that it was largely driven by rebalancing efforts at the end of the year.
In fact the response in gold and silver has been different enough that there are a lot of researchers saying, "We really can't look at gold and silver as being in the same asset class. They're very different."
HAI: Does this acceptance of gold as a corollary security in a portfolio change how we look at gold from a research perspective? If I'm trying to draw conclusions about gold in a relationship with inflation, the period in which I'm looking — if I go back and go over a study in the 70s — is that even relevant anymore? Or are we actually in one of those dangerous periods where we say "this time it's different?"
Steve Cunningham: I think we have to start to look at gold a little bit differently. People are motivated to hold gold for similar reasons as they always were. That's not changing. But certainly the availability of new vehicles is going to have to change the demand side of the market. They just have to. And we've got to be aware of that.
I think there's going to be a lot of growth in gold and in securities portfolios. I think that trend is going to continue. And then you're going to see more correlation with other kinds of assets. So I'm inclined to think that we've got to look at it a little bit differently. You're going to see some shifts in the way that gold responds to macroeconomic news.
If there are changes in monetary policy, for example, that are going to imply a shift in securities prices, that may cause a response in Gold Prices. Whereas that might not have happened in the past.
There may be linkages there that we have to explore. And we have the problem, as you point out, that you've got a break in the series. We don't have a long data series available to us since the growth and popularity of these ETFs. That makes analyses very difficult. And as you point out, the older series aren't entirely valid anymore.
HAI: If you're saying that gold has gone from being a kind of off-balance sheet investment, to one that people think of right along with stocks and bonds, that's got to be pretty bullish for long term Gold Prices.
Steve Cunningham: I think it does imply long-term demand. I think there's little doubt about that. One of the problems with gold in the past — well, if you're a day trader I guess it's a good thing — is it's volatile. And if you can play it right you can make a lot of money. But for most people it doesn't make sense to try to day trade something like gold. They're just not up to the task.
But with these ETF's, you can just put it in a security portfolio. And a lot of studies have shown, including our own, that if you allocate 5% to 10% of your portfolio to gold that you actually improve the returns and reduce the risk in your portfolio. So you're not as trapped into that volatility.
For most people that's a much more comfortable position. They're taking advantage of the good qualities in gold and not having to try to spend the inordinate amount of time it may take to track gold and trade it successfully. Before, they would not have gone there because they couldn't handle the volatility.
HAI: One concern folks have expressed with the rise of ETFs, not just in gold, but really in all commodities, is that this is the realm of serious professional traders, exposing investors to sharks they may not have experienced before. Is that something you think that it's a valid concern? Or do you think that's always been the case?
Steve Cunningham: Certainly I think that people who are not experts find a lot of danger in trying to engage in this market. In the past there were huge transaction costs as well, but investors have always had to deal with the specialized nature of the market.
But now because of the lower transactions costs, it's tempting and you're going to bring in some investors who are not really ready to take on those risks. As you say they're going to be try to swim with the sharks, and it's going to be a dangerous go for them. But this is one of the main reasons why we don't recommend people try to trade in and out of the market.
We find that the average investor will tend to buy late and stay in too long. They'll do everything wrong. They'll be providing the profits to the others in the marketplace. But if they simply allocate, like I said, 5% to 10% of their portfolio to gold, it's going to improve their returns, reduce the risk.
They're not going to have to be that agile. The limit of their adjustments is going to be standard rebalancing efforts periodically, which allows them to essentially do profit-taking and to move into other securities that haven't performed as well. And hopefully make returns there.
It's a more sensible way for the average investors to function I think.
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