Friday, February 10, 2012

Warren And Me: Comparing Stocks, Gold and Cash

Warren Buffett has a piece in Fortune discussing why stocks continue to make sense for anyone with a long term time horizon. 

I urge you to read the whole piece. In typical Buffett fashion, he explains why the current mania for gold makes no sense for most investors.

He also politely disses bonds, quoting Wall Street investor Shelby Davis as saying,

"Bonds promoted as offering risk-free returns are now priced to deliver return-free risk."

As I discussed earlier this week, I went to an investor meeting here in Boston which discussed the investment merits of gold.  To my surprise, nearly the entire audience thought that gold should play a role in most investors' portfolios. Most investment professionals strongly believe that today's easy global monetary policies will inevitably lead to future inflationary pressures.

Buffett does not dispute the widely-held notion that paper currencies rarely hold their value in history, noting:

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income."

http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

But would gold have helped investors concerned about maintaining real (i.e. inflation-adjusted) purchasing power?

Not surprisingly, Buffett says no. He cites the simple truth that stocks since 1965 have returned nearly +36% more than gold even after the miserable equity markets for the past decade.

I started in the business a little later than Warren Buffett, in 1982.  But I decided to copy Buffett (never a bad idea, by the way), and look at what investments would have done the best job of protecting me from inflation over the course of my career.

Although recent inflation rates have been relatively low, the real purchasing power of $1 dollar has fallen by nearly 60% since 1982.

The rate of inflation over the past 30 years (as measured by the CPI) has run at about 3% annually during the period.  If you are concerned about "maximizing real returns", it seems reasonable that at a minimum you should be targeting 3%.

If I had invested $100 in 1982, my savings would have had to grown to at least $240 by the end of 2011 in order to have maintained the same purchasing power as when I started.  In other words, I would have to earned 2 1/2x my original investment - after taxes and fees - to be as wealthy I was 30 years ago.

Money market funds were the rage in the early 1980's.  Unlike current Fed policy, interest rates had been ratched to record high levels to try to slay the inflation dragon.  Money market funds offered yields higher than 15% when I started in the business, and nearly all the "experts" agreed that this was an appropriate place for the average investor.

Gold also had recently completed a record run. After President Nixon took the United States currency off the gold standard in 1971, gold moved quickly from $35 an ounce to a peak of $850 in 1980.  Some of the bloom had come off the gold blossom by the time I started investing in 1982, but still the average gold price at the beginning of my career was around $400 an ounce.

Stocks were unloved.  Articles written by academicians noted that stocks had proven to be a very poor hedge against the inflationary pressures of the 1970's, and it was hard to find anyone that was excited about the prospects for stocks at the beginning of 1982.

So given the choices - cash; gold; or stocks - what was the correct decision?

Well, I did the math, and here's what $100 invested at the beginning of 1982 would be worth today:

Cash  $400

Gold  $418

Stocks $2,228

Ah, I can hear you say, this is an unfair comparison, because stocks did so well in the 1980's and 1990's. What if you changed the starting period?

I'll address that question in my next posting.