In August 2011, a Gallup poll asked Americans what they thought would be the best long-term investment: 34% said gold, 17% said shares.
It's too early to declare a winner, but the early results are in. The exchange traded fund that tracks gold – the SPDR Gold ETF – is down 17% since the survey was taken. The S&P 500 is up 38%.
Gold has lost nearly one-fifth of its value this year alone, including more than 10% in less than a week, last week — the worst decline since the early 1980s, when the yellow metal began a two-decade slump. Whether the current slide is the end of gold's bull run, or just a short-term drop, no one knows. What is clear is that gold isn't the wealth-preserver many thought it was. Some gold stocks, like Silver Lake Resources (ASX: SLR) and Kingsgate Consolidated (ASX: KCN), have lost more than half their value in the last year.
Theory trumped by reality
It wasn't supposed to work this way. The bullish argument behind gold made so much sense. As the world's central banks ballooned their balance sheets, inflation was sure to take off. And as the government ran trillion-dollar deficits, confidence in the dollar was sure to go up in smoke.
But neither happened.
Inflation has remained in check across the world. In the US, where quantitative easing has been most sustained (and some might suggest, profligate) the Consumer Price Index has increased at an average annual rate of 1.87% since 2008. That's almost half the average level after World War II.It turns out that the vast majority of the new cash the US Federal Reserve printed never really left the Fed at all, as banks kept it parked in excess reserves. And the US federal budget deficit has been nearly cut in half as a percentage of GDP. People still talk about "trillion-dollar deficits as far as the eye can see" without realising that no such forecast exists. US government debt as a percentage of GDP is on track to fall over the next decade.
Then there are rumours that the Fed will cut its quantitative easing within a few months. "I expect we will meet the test for substantial improvement in the outlook for the labour market by this summer," said San Francisco Fed president John Williams last week. "If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year." This would have been unthinkable just a month ago.
Central banks the canary in the coal mine
To boot, gold purchases by central banks have long been cited as a bullish catalyst. But now fears are swirling that the central bank of Cyprus will be forced to dump its gold to finance an international bailout. If Cyprus, who else? Portugal? Spain? Italy?
The irony is that the goldbugs may get the story right but the investment wrong. Like any asset, gold is forward-looking and prone to wild overreactions. So prices doesn't always mesh with what's going on in the economy.
Inflation in the 1980s averaged nearly 6% — triple current levels — and gold lost more than half its nominal value. It is entirely possible that the coming years will bring high inflation, but tumbling gold prices. Just as the Internet blossomed while the Nasdaq plunged from its high in 2000, asset prices can gallop far away from the stories people buy into them for. Indeed, they usually do.
Gold and inflation don't mix
Historically, gold has surprisingly little correlation with inflation. As one Citigroup research report put it: "There is no obvious relationship between the gold price and inflation." Instead, gold correlates fairly well with two events: negative real interest rates and financial panic.
But if the economy is healing, as many think it is, real interest rates are likely to rise. And as the Cyprus bailout showed last month, markets appear to be well past the panic stages of the financial crisis. One interpretation is gold's fall is the shift in how investors perceive risk — away from a world obsessed with panic and collapse toward one focused on long-term growth.
For those in gold for the long haul, that should be unsettling. Over time, gold's real return averages close to zero. Deutsche Bank's Long-Term Asset Return Study compared the average annual real returns, between 1838 and 2012, of various asset classes.
The results were clear. Stocks gained an average of 6.49%, US Treasury bonds 2.77% and gold only 0.46%.
Foolish takeaway
The share market falling 20% or more is typically nothing for long-term investors to fret about — historically, it's a once-every-five-years occurrence, with large gains over time. Gold is different. Over the long haul, the best it will do is preserve wealth. In between, it goes through periods, sometimes decades-long, of boom and bust.
No one knows if the gold story has peaked. What we know is that it's riskier than many believed.
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The Motley Fool's purpose is to help the world invest, better. Click here for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by Morgan Housel, originally appeared on fool.com.
