Don't Believe the Hype About Gold

(MoneyWatch)  Driving a car based on what you see in their rear view mirror is not a good strategy. And neither is investing based on yesterday's returns. Falling prey to "recency" -- the tendency to give too much weight to recent experience -- leads many to buy yesterday's winners high and sell yesterday's losers low. And buying high and selling low is not exactly a prescription for investment success.

The latest example of this is gold. This interest is based on the fact that the price of gold has risen more than $700 since 2002. And there's the usual media hype because that's where the action is. Before you decide to allocate some of your portfolio to gold, consider the following:

• In January 1980, the price of gold hit $850, an increase of over $700 from its price just five years earlier. (Sound familiar?)
• The media was filled with headlines eerily similar to today's -- fears of inflation, a falling dollar, huge budget deficits and foreign policy problems.

By June 1982, the price of gold had fallen to less than $300 an ounce. And more than 20 years later, in January 2002, it was still trading at less than $300. Keep in mind that these stagnant returns don't consider the direct costs of investing in gold, let alone the lost returns you could have been earning had by investing in either equities or bonds.

One can only wonder how many investors would've stayed the course -- waiting patiently, persistently rebalancing and pouring more money into gold to maintain its weighting in the portfolio -- after watching it drop $700 and then do nothing for more than 20 years.

Spanish philosopher George Santayana warned: "Those who cannot remember the past are condemned to repeat it." If you're not prepared for another such spell, you shouldn't invest in gold. The historical record is that gold experiences long periods of poor returns followed by very short, unpredictable bursts of spectacular returns.

Here are some important facts to consider. Over the very long term, gold has provided virtually no real return. However, the attraction of gold is not a high expected real return, but that it has had a negative correlation to equities -- it has a tendency to do well when stocks are doing poorly. You certainly don't need gold to hedge inflation. TIPS are a far superior hedge of inflation, as are short-term Treasury bills. Gold does hedge some (but not all) of the risks of equity investing. It can be a haven in times of crisis when investors are seeking safety. However, you only get the benefit of negative correlation if you have the discipline to rebalance. And that can be a very tough task as the historical evidence demonstrates.

If you're going to invest in gold, you should consider this advice from Charles Ellis: "Learn from deer hunters and fishermen who know the importance of 'being there' and using patient persistence -- so they are there when opportunity knocks."