Buying Gold at the Peak

The price of gold hit a record this past week, and the news is full of stories talking about investors flocking to gold as a safe haven.  But one can't help but wonder if buying gold now is pointless.  Is gold in a bubble?  We have seen our share of bubbles in the past decade with the tech bubble and the real estate bubble resulting in massive losses for many investors.  So, what to do about buying gold?

So, are you scared to buy gold at these high prices? Those who bought at the previous peak in 1980 took over 25 years to break even. And those are nominal prices. Adjusted for inflation, those gold investors still have not made their money back. That certainly should scare you as an investor! But let's look at the situation a little more carefully and analytically and find out how much of the story is true versus mainly hype.

If you happen to take a look at the chart from 1980, you will notice that the price of gold spiked very rapidly and abruptly.  In fact, the price of gold closed above $800 per ounce only twice that month.  So for those unlucky few who actually managed to buy gold on those two days, money was indeed lost and quickly.

But what kind of investor would sink all of his funds into any investment at one time.  Only an idiot!  So even if you did lose money on that investment, you could have purchased more gold at a cheaper price.  That is the magic of dollar cost averaging!  So what would have happened to our "unlucky investor" had he bought $1000 worth of gold each January?  How long would it have taken to get back to even?

We will make the assumption that our investor buys gold at $850 per ounce that first January in 1980 and then spends $1000 at the average price each January thereafter.  When I do this in an Excel spreadsheet, I come up with the following info:

• Our investor is profitable in January 1988 after only 8 years.  This is because the price of gold that January is $476 per ounce.  Our investor then is negative again until 2004 due to the low price of gold
• As of 2010, our investor has purchased 77 ounces of gold for a cost of $31,000.  These ounces are worth $86,063 at a gold price of $1117 per ounce.
  

But you may argue that our investor should be investing in stocks instead.  So I used the same approach by having our investor purchase $1000 worth of the S&P 500 index using the closing price for the month of January from 1980-2010.  For example, $1000 purchased 8.7 shares of the S&P 500 Index at the January 1980 close of 114.  The results:

• Our investor had a cumulative profit every year with the exception of 1982.  This is not surprising given the fact that the greatest bull market in stocks in history occurred during this time frame.
• What is surprising is that our investor at the end of 31 years has 88 shares of the Index worth $100,363 at a closing price of 1138.  I am actually shocked that the results are this close considering the bull market in stocks and the bear market in gold.

If you consider the values as of this writing, gold is at $1256 per ounce giving a value of $96,712 to the 77 ounces of gold, and the S&P 500 closed at 1117 giving a value of $98,296 to the 88 shares.  The difference is now only $1584 in favor of the stock index.

The moral of this article is that as investors we shouldn't be afraid to invest in gold at these high prices. Nor should we be afraid of investing in stocks. Instead, we should invest consistently through bull and bear markets regardless of the vehicle since dollar cost averaging will allow us to purchase more when prices are low and less when prices are high.

Over the course of a working lifetime, this is a profitable way to invest.