09/01/2010 02:17 pm ET Updated May 25, 2011

Fool's Gold? Four Reasons Gold May Be Overhyped

The price of gold reached new highs in spring 2010, spending most of May around the $1,200-an-ounce mark. Clearly, gold is big. Why all the hoopla?

Gold is a security blanket people turn to in troubled times, when a chunk of metal seems refreshingly straightforward in a financial world of asset-backed securities and exotic derivatives. Moreover, gold is popular as a hedge against inflation--the idea being that gold has an intrinsic store of "real" value that keeps up with the value of goods and services even if the price of those goods and services rises. This is in contrast to money deposited in bank accounts, which lose purchasing power if low savings account rates, money market rates, and CD rates are overwhelmed by inflation.

Gold's recent popularity--reflected in its sky-high prices--reflects the uncertainty that many investors have about the economy. Is this reputation justified? A look at the facts suggests that gold may be overhyped as an inflation hedge or safety investment.

Four Reasons Gold May Be Overhyped

Before you jump into buying gold on the premise that it will act as a hedge against inflation, consider these four reasons for thinking twice:

  1. Gold has a volatile price history. The Consumer Price Index (CPI), the most common basis in the US for measuring inflation, has risen in 39 of the past 40 years. If something is to be a reliable hedge against inflation, it would have to show similarly regular increases in price. Gold, however, is nowhere near that consistent. The price of gold has risen in 25 out of the last 40 years--not bad overall, but by no means steadily keeping pace with inflation. Even in high-inflation years, gold's track record is less than ideal. The CPI has risen by 5% or more in 11 of the past 40 years, and gold actually declined in price in 4 of those years. In fairness, gold has had some spectacular gains at times, but it depends on what time period you look at. The bottom line is, gold has not been the consistently reliable hedge against inflation it's been made out to be.
  2. Emotional expectations about inflation may already be built into the price of gold. One thing you should examine when buying any asset is what expectations are already reflected in the price. Gold has had a spectacular run, rising by more than 300% in the past decade. That suggests some pretty optimistic sentiment about gold is already built into the price. If you buy gold when the price is this high, are you buying an inflation hedge or an inflated asset? The financial markets have seen a series of boom-and-bust bubbles in recent years, from dot-coms to real estate to oil. At around $1,200 an ounce, is gold nearing the peak of one of those cycles?
  3. Gold does not produce income or earnings. The focus on price is essential with gold, because all you have going for you is the hope that someone will pay more for it in the future than you paid for it. If gold fails to rise in price--and it went about 25 years, from 1980 until 2005, with no net increase in price--there are no earnings, dividends, or interest payments generated in the meantime. It is just dead money under those circumstances and may even cost you something to store and protect it.
  4. Gold is not diversified. Stocking up on gold can mean putting too many eggs in one basket. As an alternative, if you are concerned about commodity inflation, consider buying a broad mix of commodities, covering areas such as food, building materials, and energy.

Gold can have a place in a mixed investment portfolio. But as with any investment, you need to consider the price you pay and keep the size of your position in proportion with your other investments.

It's OK to buy gold, as long as you're sure you aren't buying hype.

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Fool's Gold? Four Reasons Gold May Be Overhyped