Investing in anything is usually preceded by the thought: what is there to win and what is there to lose? There has been a lot of discussion about the upsides of the gold rally but little if nothing has been said about the potential losses. Clearly, many people are wary of investing in gold because they fear that the gold price could suddenly crash.

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Gold has so far attracted only $5.4 billion worth of private investment in 2010. At the same time, investors poured $22 billion into emerging market mutual funds and $155 billion into bonds. While some commentators have labeled gold a bubble, these numbers show the exact opposite. Being a tiny fraction of the bond market’s value, gold remains a niche investment. The fear of the unknown keeps savers from investing in gold, and the media hype is not helping.

Most people perceive gold to be a speculative investment whereas cash (CDs), bonds, real estate and managed investment plans are considered to be safe, conservative investments – but how likely is a sudden crash to occur in the gold price? If history is any guide, it’s not likely at all. In fact, gold has less surprises for you than any of the assets mentioned above.

1833-1969: Virtually no setbacks in the price of gold

The dollar-gold exchange rate was set to $18.93 per ounce in 1833 and there was virtually not a single notable year-on-year drop, with the exception of 1931 until 1970 when it fell 17%. It is interesting to note, considering that in 1931 and 1932 the general price level also dropped about 10% in each of these two years, that gold didn’t lose any real purchasing power during the deflationary Great Depression but actually gained some.

1970-2010: Losses in gold minimal compared to gains

In 1971, with the U.S. abandoning the gold standard and, as such, no longer guaranteeing the fixed exchange rate of $35 per ounce, gold began trading freely around the world and the gold price became more volatile. Has gold since become a risky investment?

Even in the post-gold-standard years, gold has never surprised with a sudden crash – with one exception. In January 1980, the Soviets invaded Afghanistan… and this geopolitical earthquake made the gold price skyrocket from $559 to $843, only to fall back to $668, all within the one month of January 1980. It is probably safe to say, however, that this was a very short window of opportunity and virtually no private investors managed to sell their gold at the peak that lasted only 2 days.

In order to study how much a typical leisure investor could possibly have gained or lost by investing in gold between May 1st 1969 and May 1st 2010 I have computed the gold prices for the first trading day of May of each of those years. Let’s see what my results were (I highlighted the top four losses and top four gains):

For our investor, the maximum loss suffered in any one year in the past 40 years was -29.1% in May 1982. Frankly, I can’t think of an investment that offers notably higher safety. Commodities, stocks, mutual funds, currencies, bonds,  real estate – all of these can lose 30% or more within a year easily. Actually, I bet that I could find annual losses of 50% and more in every single one of those markets in the past 40 years. Even if you think of bonds, they can still easily lose 30% or more within a year if the currency they are denominated in drops. The same applies to cash. If your currency loses 30% in international comparison (which is nothing unusual), your imports (which for many people are the main part of their consumption) will soon get more expensive by a similar, if not greater, margin.

It seems that gold is one of the most stable investments out there – it just doesn’t burst. Even after the supposed “gold bubble” of 1980, there was no bursting. Rather, it was a gradual deflation with enough time to get out. Even our imaginary investor didn’t suffer any notable damage and had plenty of time to exit before taking a loss.

Two more interesting things should be noted:

• Each of the top four significant losses was followed by a year with a gain.
• The maximum losses were generally much smaller than the maximum gains. While the maximum annual loss was around 20%, the top four hikes were all above 50%. In other words, gold combines [both] limited downside with great upside potential.

The last point mentioned [above] is not a coincidence. Any crisis in the global financial markets usually causes a run on gold and an over-proportionate price spike  because the amount of physical gold available for investing is limited. [Furthermore,] while financial crises set in fast, the recovery is usually slow. [Such a] recovery is bad for the gold price but because it is slow the deterioration in the gold price is gradual. Stocks and most other markets act in the opposite way. They grow slowly and crash fast.

The price of gold “grows” fast and “crashes” slowly making it an ideal cushion for any investment portfolio.

1980s, 1990s, 2000s … what’s next for gold?

Of course, you may argue that during the 1980s and 1990s gold was a miserable long-term investment. I would agree with that. Gold lost 87% of its purchasing power between 1980 and 2000 but exactly because of the property described above, everybody had enough time to get rid of their gold. There were plenty of signals that gold would not be a good investment in that period-interest rates were high, emerging economies ensured attractive returns from the stock markets and the gold price was being watered by the central bank gold sales. Let’s compare the signals from back then with those of today:

Signals 1980s-1990s	Signals 2010s
Fed’s Paul Volcker made it clear that he was serious about fighting inflation, raising the prime rate to as much as 21.5%	Fed’s Ben Bernanke does not appear to be serious about fighting inflation at all with the prime rate staying at sub 1%
The Soviet Bloc fell apart which created tremendous, long-lasting tailwinds for the stock markets throughout the 1990s; Asia was booming	We have no fresh emerging markets to provide expansion and growth
The IMF and central banks were selling gold and they were loud about it. The massive sales by the Bank of England finally brought gold to historical lows in 2001	Central banks will become net gold buyers in 2011, after 17 years of net gold sales

The bottom line: the signals of today are the exact opposite of those we were seeing in the 1980s and 1990s and are telling us to buy gold and I haven’t even touched on the topic of our bankrupt governments that can only pay for old debt with printed money, thus diluting the value of cash already in circulation. Cash, CDs and bonds are outright poison at this point yet that is where most of 401k and IRA money is – and is going… [Frankly,] if you care about your retirement, please have a look at gold. Remember the learnings from above. If gold peaks, it will likely deflate slowly because it takes a long time to restore sanity.

Conclusion

Those of you who have already been praising gold’s current prospects to your friends-why not mention the downside the next time. It is one of the best arguments for gold. If you are a conservative investor:

You must take a closer look at gold.

*http://www.goldinmind.com/gold-basics/how-much-can-you-lose-by-investing-in-gold.html

Editor’s Note:

• The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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