By David Galland
In the same way that the Google brand has become synonymous with Internet search, and Q-tips with cotton swabs, the name Warren Buffett has become tightly associated with investment excellence.
Justifiably so. Business Insider recently calculated that a $1,000 investment in Berkshire Hathaway Class A shares back in 1964 when Buffett took over the company would be worth about $11.6 million today.
So, why does Buffett ignore gold as part of his investment mix? In his own words, Buffett doesn’t believe in owning what he would term a non-productive asset and has gone on record deriding gold is an inanimate object “incapable of producing anything.”
Given Buffett’s outsized influence within the broader investment community, it’s no wonder mainstream financial media, brokerage firms, and even your local financial planner have no interest in—and no knowledge about—the yellow metal.
Which brings us to the central question of this article: How can it be that, despite the role gold has played as a store of wealth since the very beginning of recorded history, Buffett came to believe gold has no place in an intelligently allocated investment portfolio?
Back to Benjamin?
In my opinion, Buffett’s views on gold can largely be traced back to his mentor, Benjamin Graham.
Graham, author of Security Analysis (1934) and The Intelligent Investor (1949), is correctly respected as one of history's most knowledgeable investors.
He was Yoda to Buffett’s Skywalker.
Over a career spanning 1926 to his retirement in 1956, he refined his investment theories, in time becoming known as the father of value investing. Much of modern portfolio theory is based upon Graham’s work.
According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued.
Logically then, investors can enhance returns and reduce risk by reallocating their portfolios accordingly. A quick look at a long-term chart supports Graham's theory. As you see, there are clearly periods when one asset class offered a better value than the other:
But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through 2008, any portfolio allocated solely between stocks and bonds would have at best treaded water… but mostly trended down. To earn any real return, an investor would have needed to seek alternatives.
Studying this next chart reveals that gold was exactly that alternative—a powerful countertrend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham's allocation model.
Blame It on FDR
There is a straightforward explanation for Graham overlooking gold as an asset class in his investment models; for most of Graham's adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed.
Specifically, in 1933, FDR pushed through legislation making private ownership of gold illegal. And it wasn't relegalized until late 1974.
Overlay that with Graham’s time on Wall Street (1926–1956) and, in fact pretty much his entire life (he died in 1976)—and it becomes clear that his career lacked any reference point to gold.
In fact, Graham never lived during a cycle in which gold was unmistakably a better investment than either stocks or bonds.
All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold?
We can never know.
We can know, however, that given Graham's outsized influence on investment theory, there is little question his lack of experience with gold, and therefore its absence from his observations, has had a profound effect on how most investment professionals view the precious metal.
This, in my opinion, goes a long way toward explaining the persistently low esteem in which gold is held by the mainstream investment community even today. And, as a consequence, the reason Buffett and 99% of investment professionals continue to completely ignore gold as an asset class to be included in a portfolio mix.
A couple of takeaways: first, perhaps now you can stop wondering why your broker, the talking heads in the financial media, and Warren Buffett continue to misunderstand gold as a portfolio holding.
More important, however, is that in order to have sustained, long-term investment success, one must accept that an intelligent portfolio allocation needs to include not two but three broad categories of investment—stocks, bonds, and gold—with the amounts allocated to each guided by relative valuation.
Investors who understand this tenet have an almost unfair advantage over other investors as it allows them to get positioned in gold ahead of the crowd and enjoy the bulk of the ride while others sit on their hands.
So when you hear commentators ridiculing gold as a barbarous relic, lamenting they cannot eat it, or smugly asserting it produces nothing, you now know they’re operating with a severe handicap in their own portfolios.
Students of monetary history know that throughout the millennia gold has fulfilled a very important and specific purpose in a portfolio as real money that protects net worth during periods marked by excessive government debt and currency debasement such as we are currently experiencing.
Likewise, there are times and places - Greece providing a tragic example as I put the finishing touches on this post - where cash becomes trash, along with local stocks and bonds. Those currently standing in bank lines hoping to retrieve some small percentage of their savings could have literally saved themselves from financial ruin by including gold in their asset mix.
These are important lessons.
Ignore them at your peril.