Investing in gold
April 02, 2004

In response to last week’s column, Don wrote to say that terrorism’s influence on the gold price does not make the metal a bad investment choice. He makes the point that the biggest increase in the gold price occurred during 1979 and early 1980, mostly due to tension between the United States and the Middle East, exemplified by the Iranian Hostage Crisis: a terrorist act. Don then asks, rhetorically, why that would not have been a good time to invest in gold.

He goes on the say that people turn to gold during times of political instability and uncertainty, and that the success of the terrorist act in Spain (in changing the political climate there) indicates that we are likely to experience more such atrocities. Given that terrorism will continue to influence gold’s future, the prospect of increased terrorist activity is a sound basis for investment.

I agree with Don almost entirely. History confirms that people tend to buy gold during times of trouble and uncertainty. The situation today is quite analogous to the late seventies. There is tension between the United States and Muslim countries and as far as terrorism goes, things are likely to get worse before they get better. It is also true that a lot of money could have been made buying gold during the late 1970s. But, and this is where I disagree with Don, buying gold in anticipation of increased terrorism, or the threat of continued political and social uncertainty, is not a good investment idea.

Predicting the timing and severity of terrorist activity is nearly impossible. Even if we are certain that terrorism will increase, we don’t know whether there will be a major strike this year, or next. Perhaps nothing will happen for three years. Or maybe there will be a spate of activity later this year, and then a lull. Either way, most people are likely to feel the urge to buy gold when there is an increase in terrorist activity, or uncertainty, or both, precisely when gold will be trading at higher levels.

Similarly, they are most likely to sell their gold when peace and calm prevail, since they would no longer feel compelled to own a non-income-producing metal; precisely when gold is trading at lower prices. That is why most people tend to lose money on their gold “investments”.

To state the obvious, you have to buy when the price is low and sell when the price is high. For gold that means you buy it during times of peace and calm, when the threat of terrorism seems remote and the price is relatively low. You should sell gold when there is turmoil and the price is high. After all, if you bought gold as an investment, you intended to make a profit.

So while I agree completely with Don that the probability of increased terrorist activity is high and that the gold price could rise as a result, the unpredictability of terrorism and human nature do not make increased terrorist activity a sound basis for investing. Buying gold in anticipation of terrorism could, however, be an excellent speculation. Also, gold is a superb form of insurance against increasing political and social turmoil. The difference is psychology, not semantics.

Investing requires a high degree of certainty in the worth and timing of your expected return, with a clear understanding of the risks attached. Good investments can often be held for long periods of time, with relatively low risk, and a fairly certain return on capital. Buying gold on the basis of increased terrorist activity, even if it occurs and you make money, does not qualify as an investment. It is pure gambling because predicting the extent of paranoia, and hence the extent of the increase in the gold price, is not possible. At best you could only have a low level of confidence in the outcome and timing of your return. And if you bought gold in anticipation of increased terrorist activity and such activity does not materialize in the short term, what do you do?

Gold is, however, an excellent form of insurance. But, as with any insurance policy, you are always better off if you do not have to collect on it. The psychology of buying gold as insurance is very different from buying gold as an investment. There is no profit motive and it makes sense to buy gold during times of increased terrorist activity, which is what the public tends to do. If you end up buying gold at elevated prices because of an increase in uncertainty, or as in our present case, an increase in terrorist activity, you can logically justify the decision because you are merely buying insurance during times of turmoil at a higher premium. But then don’t turn around and feel blue if the gold price declines when things calm down. If you didn’t need to cash in your gold to stay alive, or to take care of other needs, you should be thankful. It was an insurance policy that, at the end of the day, you did not need.

People speculate (gamble) on just about anything -- gold is no exception. Astute speculators, like successful gamblers, understand their game intimately. A speculator’s gold market is very different from an investor’s, or someone buying gold for insurance.

A speculator might buy gold on the assumption that terrorism is on the rise and therefore the gold price is likely to do well. Don’t, however, confuse that with investing. A true speculator will know when to cut his losses or ride a winning streak much better than someone who is under the impression that he is investing when in reality he is gambling.

Whether you buy gold as an investor, for insurance, or as a speculation does not matter. But in order to profit you must know into which category you fall, and be very clear about your own strategy and psychology.

As an aside, if you’re curious how much the war in Iraq is costing the United States, take a look at www.costofwar.com.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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