by Archie M. Richards, Jr., CFP^®
April 4, 2005

Using gold investments as a small part of a personal investment program is a great idea. Using gold as a foundation for the nation's monetary policy is not.

All paper currencies have eventually become worthless, but gold has always held its value. It doesn't rust or decay. Its rarity enables a large amount of value to be stored in a small space. Unlike jewelry, antiques, and fine art, the price at which you can sell gold at a given moment is close to the price at which you can buy it at that moment.

Gold's price fluctuations do not match those of stocks or bonds. A modest amount of gold added to an investment portfolio therefore cuts risk.

To demonstrate the effect, the American Institute for Economic Research (aier.org) constructed two hypothetical portfolios:

• The first had three equal parts: stocks of large companies, stocks of large companies whose prices were low in relation to earnings, and stocks of small companies whose prices were also low in relation to earnings.

• In the second portfolio, a 10 percent portion of gold bullion was added. The percentages of the other three sectors were reduced from 33.3 to 30 percent.

Both hypothetical portfolios were run from 1968 to 2003. Portions of the various investment sectors were bought or sold each year to return each sector to the desired percentage.

The addition of 10 percent gold reduced the annual rate of return of the entire portfolio by a tiny 0.07 percentage points. But it cut the portfolio's volatility (as measured by the standard deviation) by a more significant 2.31 percentage points. Any reduction of volatility helps us to avoid selling when prices fall, not to mention, sleep better.

The best way to hold gold is to buy an exchange-traded fund, the iShare Comex Gold Trust (IAU). As the price of gold goes, so goes the ETF. For income, acquire gold mining stocks.

Fortunately, the United States does not place gold at the foundation of its monetary system. Doing so would be foolish.

Under a so-called "gold standard," the government would proclaim that a dollar is worth a certain amount of gold. Let's say $400 is made the equivalent of one ounce of gold. If you turned in $100 to the government, you'd receive a quarter-ounce. If you turned in a quarter-ounce of gold, you'd receive $100.

Under these circumstances, no dollars would be created unless the government holds sufficient gold to back them. The money supply couldn't grow faster than the supply of new gold, limiting inflation.

But a gold standard is bad policy, because it doesn't solve the basic causes of inflation. A gold standard prevents inflation for a while. But if the underlying causes are not cured, the dam eventually breaks and severe economic disruption occurs.

The underlying causes are as follows:

• People want government to give them more in benefits than they're willing to pay for in taxes. To cover the difference, the government creates money in excess, causing prices throughout the economy to rise.

• Legislators remain in office indefinitely, with a reelection rate of over 98 percent. The longer they remain, the more they supply government handouts. Also, the more their constituents want to reelect them, because legislators with seniority can hand out more pork.

Here are the solutions for inflation:

• The people must learn from experience that government handouts suppress personal initiative, discourage private economic activity, and create dependency. They must learn that dependency fosters yet more demand for damaging government handouts. They must understand that no society is perfectible, that free markets meet most needs, and that voluntary gifts can satisfy most of the rest.

• Limits must be placed on the terms of legislators. Legislators subject to term limits are more inclined to say no to government handouts. A more rapid turnover also hastens the speed at which government policies keep pace with citizen learning.

Stopping inflation requires citizen learning. It also requires a suitable turnover of legislators, improving the pace at which government adapts to what the citizens have learned.