Ben Graham’s Curse on Gold
John Mauldin
February 20, 2012


This week we have a shorter Outside the Box, from my friend David Galland at Casey Research, with an interesting insight into why gold can be considered as a poor investment by some rather influential investors (like Warren Buffett) while others may see it as the core of a diversified portfolio. As usual when I use someone’s material for an OTB, I include a link at the end, if you want to look deeper. The rather large team at Casey Research specializes in gold, natural resources, and energy-related investments, for those with such an investing bent.

As a quick note, the feedback on this weekend’s letter on taxes has been substantial, and a great deal of it is quite good and worth thinking about. Many bring up real problems with the position I took in my letter, and I may surprise you by agreeing with some of them. My intention right now (barring something happening between now and Friday night) is to take some of the better statements and questions, and answer them. I am not married to any specific plan. I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit. I think it will make for a very interesting letter. I do read your feedback, by the way. So if you wanted to respond and wondered if I might actually read it, the answer is yes I do, and this week will answer as many as I can.

And to answer a question I get a lot, I buy a little physical gold every month. I don’t even look at the price. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can’t actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don’t trust the (insert your favorite expletive). Just a little insurance, you understand.

So, until we connect this weekend, have a great week!

Your I am not a gold bug analyst,

John Mauldin, Editor
Outside the Box

Ben Graham’s Curse on Gold

By David Galland, Casey Research

It seems that the mainstream investment community only takes a break from ignoring gold to berate it: one of gold’s most outspoken critics, uber-investor Warren Buffett, did so recently in his latest shareholder letter. The indictments were familiar; gold is an inanimate object “incapable of producing anything,” so any investor holding it instead of stocks is acting out of irrational fear.

How can it be that Buffett, perhaps the most successful (and definitely the most well-known) investor of our time, believes that gold has no place in an intelligently allocated investment portfolio?

Perhaps it has something to do with his mentor, Benjamin Graham.

Graham, author of Security Analysis (1934) and The Intelligent Investor (1949), is correctly respected as one of history’s most knowledgeable investors. Over a career spanning 1915 to 1956, he refined his investment theories, in time becoming known as the father of value investing. Much of modern portfolio theory is based upon Graham’s work.

According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham’s theory clearly shows periods when one asset class offered a better value than the other:

But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives.

It’s clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham’s allocation model.

But this missing asset class is entirely understandable: for most of Graham’s adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn’t re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds.

All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold?

We can never know.

We can know, however, that given Graham’s outsized influence on investment theory, there is little question that his lack of experience with gold, and therefore its absence from his observations, has had a profound effect on how most investment professionals view the yellow metal. This, in our opinion, goes a long way toward explaining the persistently low esteem in which gold is held by the mainstream investment community. And, as a consequence, its widespread failure to even be considered as an asset class.

A couple of takeaways: first, perhaps now you can stop wondering why your broker, the talking heads in the financial media, and Warren Buffett continue to misunderstand gold as a portfolio holding. More importantly, however, is that in order to have sustained, long-term investment success, one must accept that an intelligent portfolio allocation needs to include not two but three broad categories of investment – stocks, bonds and gold, with the amounts allocated to each guided by relative valuation.

[JFM here: I would suggest additional broad categories of investments depending on your personal situation. Alternative investments like commodity trading funds. Low leveraged income oriented real estate consistent with your ability to handle the ups and down of the rental/leasing market and shorter term carry costs. I for one am not psychology capable of dealing with renters, of whom I am one. I want service and you to pay for major maintenance, and the ability to move at the end of my lease. My choice, not dependent upon your cash needs. But I know of plenty of people who can do that and have amassed considerable portfolios over time. Perhaps your own small business that has the potential to grow. Investments outside of your country of residence. Etc.]

Investors who understand this tenet have an almost unfair advantage over other investors as it allows them to get positioned in gold ahead of the crowd and enjoy the bulk of the ride, while others sit on their hands.

So when you hear commentators ridiculing gold as a barbarous relic, lamenting that they cannot eat it or smugly asserting that it produces nothing, rest contently in knowing that they’re operating with a severe handicap in their own portfolio. Meanwhile, we’ll prosper, armed with the understanding that gold fulfills a very important and specific purpose in a portfolio, namely as real money that protects net worth during periods marked by excessive government debt and currency debasement such as we are currently experiencing.

Given the powerful influence of Ben Graham and his disciples, his curse on gold will not go quietly into the night. But it should.

David Galland is managing director of Casey Research, which provides independent investment analysis on a subscription basis to a global network of over 180,000 self-directed investors and money managers. Recognizing the emerging bull market in gold early on, in the late 1990s, Casey Research formed a metals and mining division that has grown into a leading provider of actionable gold and resource intelligence. For investors looking to become familiar with the asset category, Casey Research offers a monthly newsletter, BIG GOLD (try it risk-free for 90 days), focusing on undervalued opportunities in mid- to large-cap producers, as well as best practices in buying, holding and selling precious metals. Learn now why it’s more important than ever to invest in gold and gold-related equities.

Category: Gold & Precious Metals, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

6 Responses to “Ben Graham’s Curse on Gold”

  1. forwhomthebelltolls says:

    Didn’t get past:

    “For much of the 1970s and again from 2001 through today, ANY portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation.”

  2. ottnott says:

    “I just want to solve the problem and am open to anything that is politically feasible and makes sense, as long as we solve the basic problem of the deficit.”

    You need to be more clear (and likely more open) to how “the problem” is defined. So far, you’ve sounded much like a doctor who is so focused on a patient’s rising weight that you are ready to prescribe a strict diet and exercise regimen without even bothering to determine if the patient is pregnant or is still a growing child.

  3. jaymaster says:

    Yeah, we get the diversification part. But like JFM said, why limit it to gold? How about land, real estate, guns, ammo, food, water, oil, gem stones, hard wood, forever stamps, antiques, children, etc? Many of those can be counter cyclical to stocks and bonds too.

    The real argument I get from this, besides diversification, is basically “Buffett’s mentor wasn’t allowed to own gold, so Buffett and other modern investors like him don’t understand it.” Maybe a valid point, but certainly not a justification to go out and buy gold, especially at all time highs.

    And this actually touches on one of the potential downsides to gold. He admits the government didn’t allow us to own gold for a long time. What’s to stop them from confiscating it and making it illegal again?

  4. Non Sequor says:

    My complaint about gold is that you’re ultimately dependent on other gold bugs. Gold bugs track the price of gold against other metrics and buy more gold when they regard the price as low and buy less when they regard the price as high. They also buy more when they have more spare cash. The rest of the public for the most part does not buy gold at all, except for jewelry and some industrial uses.

    So this leads me to the question of what the end game for gold ownership is. If the dollar were to collapse tonight, and all of our non-gold assets took a 50%+ hit all at once, are you going to be able to buy gold from me? What fraction of the gold bug community will be able and willing to buy gold from me in this catastrophe scenario? And if I’m forced to sell to someone who isn’t a gold bug (pawn shop, cash 4 gold, etc.), how much of a hit am I going to take versus the pre-catastrophe valuation determined by gold bugs?

    The idea that you should have a portion of your money invested in something that will retain its value in a financial catastrophe is a good one, but I’m not convinced that an asset only traded by a subset of the investment community, which is in turn a subset of the population at large, can do that. Instead of buying gold each year, I’ve been buying tools and I’ve been learning new skills. I think having things and knowing how to do things that are always useful, regardless of circumstances, is a better way of preparing for the financial apocalypse than investing in something that may or may not have a use tomorrow.

  5. bonzo says:

    Bonds and stocks is indeed limiting, not because it leaves out gold, but because it leaves out real-estate, which is the third major asset class. Real-estate did fine in the stagflation of the 1970′s. And why does the author think bonds did poorly from 2001 to today? Even a 50:50 split between stocks and bonds did fine during that period. A 3-way split between stocks/bonds/real-estate would also have done well.

  6. favjr says:

    Sounds like he’s talking about some version of a “Permanent Portfolio” to me. But gold usually does well in negative interest rate environments whether inflationary (1970s) or deflationary (now).