Saturday, 18 September 2010

Gold Does Not Produce Income

Even though there have been fears of a double-dip, the stock market has gone up. The All Ords has moved from about 4500 last month to 4700 now. Surveys indicate that fears of a double dip are starting to go away. During this period of stock market growth, the price of gold continues to go up as the US dollar continues to deteriorate. Gold is reaching US$1270 per ounce now, citing some people to call it a bubble.

But if gold is a bubble, why would it be? Before we label any asset price increase a bubble we must ask ourselves first if there is a sensible reason for asset price going up. Gold is valuable because its chemical properties make it suitable for use as a currency (read Properties of Good Money for more information about this concept). Many currencies around the world are being devalued because of money printing by government, leading to the price of goods going up. Gold cannot be easily produced as it requires mining, which is difficult. This means that the rarity of gold, which affects its value, is out of the hands of government and therefore gold is free of corruption.

The ABC came out with an article claiming that gold is a bubble (read The Gold Rush is Fools' Gold). The reasons for this are uninspiring. The article mainly appeals to authority by citing Gearge Soros. It also claims that because gold produces no income (e.g. real estate produces rent, stocks produce dividends, etc) then gold therefore has no value and therefore it must be in a bubble. 
"Gold will never generate cash flows, so for purist investors it has no value. From this point of view, gold itself is in a bubble driven by investor fear, implying that the price of gold will collapse when investors realise the world is not ending," Ms Howitt noted in a statement.
This is the worst argument I have ever heard. An investment doesn't need to produce cash flow to be valuable. An investment is any asset that holds or increases in value. Some assets produce income, which gives it value. However, there are many assets that do not produce income that can go up in value, e.g. gold, paintings, and wine.

If you invest in stocks at the moment in Australia, you'll get a dividend yield of about 3 per cent. If you invest in bank term deposits, you'll get about 6 per cent. If we went by the rule that an investment's income is the only indicator of the investment's value, then it would be wise to invest in bank term deposits. However, many people invest in shares because even though the dividend yield is relatively lower now, there is the potential for future capital growth as companies reinvest profits back in their businesses. The most successful investment in history--shares in Warren Buffett's Berkshire Hathaway--has never produced any income. However, term deposits, which give income yields of around 6 to 8 per cent on average, have zero capital growth. Measuring gains with both capital gains and dividends shows that the historical performance of stocks and gold have been better than than that of term deposits.

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