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Gold and Silver, What Goes Up...

The prices of many lesser-followed commodities have dropped significantly in recent weeks. Couple that with what history has shown us about how quickly the prices of gold and silver can drop, and you have a perfect reminder of why speculating can be dangerous for your portfolio.

While the increasing prices of gold, silver and oil have received all the attention, the prices of some other less-watched commodities have taken a sharp turn in the opposite direction. The Wall Street Journal noted that the price of cotton has fallen 17 percent since it set a record high in early March. Sugar is down about one-third from its multidecade high set in February. Lead and zinc have tumbled since shooting up last year, and copper has fallen 6 percent this year.

The research on expert forecasters demonstrates that there are no good forecasters, so I certainly won't add to the mix. However, I thought it worthwhile to point out that commodities have a tendency to exhibit rapid increases in prices, then fueled by a herd mentality and momentum traders, these rapid increases can develop into bubbles. And while they often take years to develop, bubbles can burst with great speed. The following is a reminder of just how quickly prices can collapse.

On January 21, 1980, the price of gold hit the then-record high of $850. By the end of the year, it had fallen to $590, a drop of over 30 percent. And by March 19, 1982, it reached just $316, a fall of 63 percent.

Silver took an even more spectacular ride, hitting a high of about $48 an ounce in 1980, only to fall back to under $5 in 1982.

The rapid rise in prices of gold and silver were fueled by very easy monetary policy, with negative real interest rates. When the era of loose money ended, the bubbles burst. I'm certainly not predicting that we'll see a repeat. However, I'm providing a warning -- it's possible, if not even likely. Just as a change in monetary policy led to a change in prices in 1980, an end to the current policy of monetary ease can lead to a repeat performance.

There are two other reasons to be cautious and to avoid being caught up in the speculative hype:

  • The prices of both gold and silver are now way above the marginal cost of production. When that happens, you get new supply (though it may take some time for production to come on line).
  • Unlike oil, which is a depleting asset, all the gold and silver ever mined is still around and is available to be sold. That means supply can quickly swamp demand as those family heirlooms that have been sitting in attics become prime material for melting down.
There are good arguments for considering allocations to either gold or a broad based commodities fund (with my preference being the latter). However, that allocation should be part of an overall plan, not a reaction to the all the hype about gold.

One of the worst mistakes you can make is to buy yesterday's winners at high prices and sell yesterday's losers at low prices. The bottom line is this: If you have an allocation to commodities in one form or another, stick with it. And that means rebalancing, selling some whenever the allocation exceeds the maximum tolerance range set in your investment policy statement. Otherwise, I suggest missing this party.

More on MoneyWatch:
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Three ways I can help you become a wiser investor:

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