Thursday, August 1, 2013

Au Shucks: Gold and the Average Investor

Disclaimer/Disclosure: This post is not intended to be investment advice.  I currently hold no gold, nor anti-gold (non-standard term: read on if you dare) in my portfolio of assets, nor do I plan to acquire a position in gold in connection with my writing this post.  The post is for entertainment purposes, but you will hopefully also find it educational if you haven't caught the discussion through some other channel.


With that out of the way, Greg Mankiw has an interesting New York Times article in which he analyzes the investment properties of gold.  Many economists get this question, "Should I buy gold?" Mankiw's answer (in a nutshell):
My instinct was to say no. Like most economists I know, I am a pretty boring investor. I hold 60 percent stocks, 40 percent bonds, mostly in low-cost index funds. Whenever I see those TV commercials with some actor hawking gold coins, I roll my eyes. Hoarding gold seems akin to stocking up on canned beans and ammo as you wait for the apocalypse in your fallout shelter.
But, then he takes a serious crack at the question, citing gold's historically low return, high volatility, and low correlation with other assets (stocks and bonds).  He ultimately concludes:
In the end, I abandoned my initial aversion to holding gold. A small sliver, such as the 2 percent weight in the world market portfolio, now makes sense to me as part of a long-term investment strategy. And with several gold bullion exchange-traded funds now available, investing in gold is easy and can be done at low cost. 
I will continue, however, to pass on the canned beans and ammo.
To a first order, this seems like sensible advice to me.  After all, Mankiw's initial impression - like mine - was to stay far away from gold as an investment.  More importantly, all of this is in an environment where naive investors are being told that there's no safer investment than gold ("buy gold" commercials will tell you something to the effect that "gold is an asset with real value.").  Much of this is nonsense.  Thus, it's incumbent upon Mankiw to push back against the tide, and push he does.

But, what was interesting to me is that John Cochrane chimed in, and eminent financial economist he is, Cochrane deepened Mankiw's first order analysis:
I think Greg made two basic mistakes in analysis. 
First, he assumed that returns (gold, bonds, stocks) are independent over time, so that one-period mean-variance analysis is the appropriate way to look at investments. Such analysis already makes it hard to understand why people hold so many long-term bonds. They don't earn much more than short term bonds, and have a lot more variance. But long-term bonds have a magic property: When the price goes down -- bad return today -- the yield goes up -- better returns tomorrow. Thus, because of their dynamic property (negative autocorrelation), long term bonds are risk free to long term investors even though their short-term mean-variance properties look awful.
Gold likely has a similar profile. Gold prices go up and down in the short run. But relative prices mean-revert in the long run, so the long run risk and short run risk are likely quite different. 
Second, deeper, Greg forgot the average investor theorem. The average investor holds the value-weighted portfolio of all assets. And all deviations from market weights are a zero sum game. I can only earn positive alpha if someone else earns negative alpha. That's not a theorem, it's an identity. You should only hold something different than market weights if you are identifiably different than the market average investor. If, for example, you are a tenured professor, then your income stream is less sensitive to stock market fluctuations than other people, and that might bias you toward more stocks.
With the average investor theorem in hand, Cochrane doesn't come to a different conclusion:
I don't come down to a substantially different answer though. As Greg points out, gold is a tiny fraction of wealth. So it should be at most a tiny fraction of a portfolio. 
There is all this bit about gold, guns, ammo and cans of beans. If you think about gold that way, you're thinking about gold as an out of the money put option on calamitous social disruption, including destruction of the entire financial and monetary system. That might justify a different answer. And it makes a bit of sense why gold prices are up while TIPS indicate little expected inflation. But you don't value such options by one-period means and variances. And you still have to think why this option is more valuable to you than it is to everyone else.
Alternatively, you could think about why the option is less valuable to you than it is to everyone else, and include anti-gold in your portfolio.  Technically, anti-gold doesn't exist, but the exchange traded funds that Mankiw mentions also allow you to hold an asset that is supposed to behave as if you hold negative gold.  I have known a few economists who invested in these funds as well.

And, a follow-on after I have already written the post, this is an advertisement in today's (August 1) Wall Street Journal.

Mankiw and Cochrane would agree, but they'd suggest using only a thin layer of gold.


  1. The one part of Cochrane's argument I don't understand is the relevance of the average investor theorem, stating you should only act different from the average investor if you are identifiably different. The premise of the blog posts are that many people may be holding a suboptimal amount of gold, and the two authors are trying to help us improve our investment strategy. Thus, it seems plausible that the average investor would have a suboptimal portfolio. Therefore, I may rationally deviate from the average investor even though we are identical (except that I believe I'm smarter than him).

    1. I think Cochrane's point is that a lot of people think that they're smarter than the average investor, but he doesn't agree that's a good basis on which to make investment decisions. In fact, he's suggesting that even Mankiw isn't so much smarter than the average investor as to deviate.

      That said, if you have to explain the wisdom of crowds about whether investing in gold is a good idea by writing a column in one of the most prominent newspapers around, you might wonder if the crowd really is wise enough about investing in gold to serve as a useful guide for your own investment behavior. That is to say that if you understand the behavioral biases of the average investor well enough, you might be able to game that in order to make trading profits as you suggest.

      But, then the strategy becomes about timing, and distinguishing fundamental value from artificial value. Right now, I believe that the average investor is over/under invested in gold, but that they'll wise up in the future. When they wise up, the price will adjust, and I'll make profit by anticipating that... but with all the market volatility, what constitutes the average investor becoming wise? When do you time your sale? These are tricky issues that I haven't quite figured out.

      Even worse, what if you're wrong about the deviation from fundamental? I think Cochrane is assuming that we are, and that (nearly) all attempts to game the market without information about real profits that is unavailable to the market will be doomed to failure.

      As you can see from my reply, I tend to ride the fence between Cochrane's perspective and the behavioralist perspective. Some asset prices are out of whack in predictable ways, but that's far from the norm. Is gold one of these predictable assets that gets out of whack? I'm not sure, but I suspect that an argument can be made that it is. In this environment, prudence (Cochrane's perspective) is a good course of action.


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