You Are About to Make a Bad Investment

Don't do it ...

Don't you invest in that just because it's popular right now. I'm warning you.

Across 10 asset classes, over a near-40-year time horizon, and in increments of three, five, and 10 years, there's one investment vehicle that made for a total loser -- a dud.

It's gold -- that blisteringly hot preciously metal -- and if you're considering it today, let me explain why you need to bypass it and move on. Although gold may well be one of your favorite items in the vault, as a long-term investment, it is just plain lousy.

Bring on the hate mail
You needn't take my word for it -- Investor's Business Daily (log-in required) pulled the data from a study conducted by two Merrill Lynch strategists. And today, very few have the gumption to say that gold is simply not worth your time. Why?

Perhaps because, as IBD wrote, "In one recent five-year period -- the one ended Feb. 7 -- [gold funds] leave a different impression. Gold funds tracked by Lipper Inc. cranked out an average annual return of 25.45% vs. U.S. diversified stock funds' 12.60%."

You can bet your bottom dollar those returns have a lot to do with the metal's current popularity. As usual, investors are chasing performance. While gold funds and industry giants such as Newmont Mining (NYSE: NEM  ) are doing fine these days, four decades worth of data demonstrate that gold is a riskier and lower-returning investment than pretty much any other.

Higher risk/lower reward
The two folks at Merrill hit the nail right on the head when they said, "Investors often lose sight of longer-term historical investment results, especially during short-term periods of extreme volatility and trending markets."

Bingo!

Short-term, return-chasing investing is precisely what is driving this modern-day gold rush and that is exactly why you should be looking elsewhere right now. But before I get to where exactly, it is important to understand just what the gold bulls are thinking.

Looking through the other side
Supporters of gold like to note that the past 40 years were an unprecedented period of growth in the American economy. We witnessed the rise of the quintessential American business -- names like Intel (Nasdaq: INTC  ) and Microsoft (Nasdaq: MSFT  ) and other companies that revolutionized or invented their industries alongside booming growth in our domestic economy -- the likes and returns of which we'll probably not experience again. OK, this may be true.

Gold bulls go on to suggest that there is no reason to believe that the next 40 years of equity returns will look anything like the prior 40. Our economy is too big and too developed ... and that's probably true too.

It's all about risk
According to them, we're entering an era of massive economic risk thanks to our miserable levels of national and personal debt. As evidence, Wachovia (NYSE: WB  ) , a cornerstone of our nation's financial industry, has nosedived more than 60% in the past year alone. Hey, don't forget about political risk from terrorism, a more competitive China, and the end of cheap fuel. Risk is everywhere.

To that I say: Where did the risk ever go?

Wasn't it difficult for Americans to buy shares of General Electric (NYSE: GE  ) during the height of the Cold War and with the underlying threat of nuclear war? Yet investors that stuck with their guns on GE made 11,328% (15% annualized) compared to a measly 385% (4.8% annualized) on gold since the start of 1975.

With all the bear markets, through the oil crises, Black Monday, the implosion of the dot-coms, stagflation, and all the economic risks you can think of, do you know which asset class was the only one that lost money in a 10-year time frame? Yup, our favorite precious metal: gold.

Goldfinger will not be pleased
I'm not bashing gold simply to bash. In fact, it isn't the worst idea to put a small slice of your portfolio in gold to diversify in case I'm wrong. But there's a better solution for the rest of your money: Go with the asset class that has consistently demonstrated the highest returns on investment with some of the lowest elements of risk: small-cap stocks.

This isn't my own unproven theory -- the data comes from the same study I mentioned before. Generally, equities trump just about every available investment alternative you have. But small caps in particular demonstrate significantly high returns with comparatively low risk. What more do you need?

The truth will make you rich
To find the best of the small-cap world, you've got to think like a great small-cap stock. Remember: the giants of industry you know today once resembled the NVIDIA's (Nasdaq: NVDA  ) and the Under Armour's (NYSE: UA  ) of the world we know now. And though our economy has matured, great companies will inevitably find their way to the top of the U.S. markets, displacing others if they have to.

That's because many of the world's best businesses -- like NVIDIA and Under Armour -- started small with great ideas on top of cash-generating business models with entrepreneurial owners at the helm. And there are plenty more out there where those came from.

If you want to be on the side of returns that smash gold in the long run, then you must allocate toward these types of stocks.

Need some ideas? Consider our Motley Fool Hidden Gems small-cap service, where our team's picks have beaten the market by 22 percentage points on average. Click here to get all of our research and recommendations free for 30 days.

This article was first published July 8, 2008. It has been updated.

Fool analyst Nick Kapur used to have a gold class ring, but, sadly, lost it. He owns no shares of any company mentioned above. NVIDIA is a Stock Advisor recommendation. Under Armour is a Rule Breakers and Hidden Gems selection. Microsoft and Intel are Inside Value recommendations. The Motley Fool owns shares of Under Armour and has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 09, 2008, at 9:07 AM, johnnymaynard wrote:

    This article writer's logic is fundamentally flawed. He compares gold to General Electric, which is a ridiculous comparison. You cannot compare the performance of one company to an asset class. There were just as many companies I could have invested in, other than GE, which would have eventually went bankrupt. That means I could lose ALL my money. If he compared gold to the value of the shares of one of the many bankrupt companies that litter the highways to financial ruin, he would find far greater multiples in gold.

    I could say that, in 1956, Mr. Kapur should have invested in rhodium, which is another metal that is considerably more precious, now, than gold. At that time, mining companies were practically giving it away as a novelty. Since then, rhodium has risen to over $9,000 per ounce. The gain would have been about 90,000%,

    Gold and other precious metals are currently an excellent investment, because of the financial and political instability afflicting the world. Precious metal never loses all its value, unlike stocks. That is important in a subprime economy buzzing along amidst a nuclear proliferation world.

    Mr. Kapur is living in the past. But, those who drive with their face glued onto the rear view mirror will, inevitably, end up crashing, because they are not looking ahead. They are looking behind. So, it is with folks like Kapur, who think that the past always will repeat itself. Patterns may repeat, but events do not. Gold and silver are the best investments, right now, because of economic and political risk. Anyone who doesn't see that is, truly, a fool.

  • Report this Comment On August 09, 2008, at 2:48 PM, mzalbatross wrote:

    BOOOOOOOOOOOOOOOOOOOO!

    And for anyone who wishes to find out HOW they zapped gold this past week, read Julian Phillips's comments from late yesterday afternoon.

    He is THE authority on central bank gold sales.

    "If 'bad' news, sell on the rumor, buy on the news."

    Quite aside from geopolitical developments this weekend, Julian gave the sector permission to buy.

  • Report this Comment On August 09, 2008, at 5:24 PM, TDLCLT wrote:

    Nick Kapur is the fool. Why don't you write an article that hasn't already been written? Do you have your own thoughts or do you have to copy something so many others have written and have been wrong about. I cannot believe someone that does not know any fundamentals is allowed to write financial information for people to read. People please listen...don't rely on information from journalist...its called journalistic risk. He/She can write anything and not be held accountable. I hope one day junk like this can be used to sue the journalist that write bad articles like this.

  • Report this Comment On August 10, 2008, at 11:13 AM, dypcheung32 wrote:

    Small Caps as a better investment? C'mon, how many small cap companies does one need to sift through to find those so-called Gems. I'm a subscriber to Motley Fool Hidden Gems, and most of the small stock recommendations are swimming in a sea of red arrows... and in some cases in triple digit percentages.

    The US economy is weak, and the recent rally is only because the EU had the honesty to tell everyone its economy is looking bleak... unlike the Fed which is fudging their GDP and inflations numbers. The truth is the US is already in a recession. The US dollar rally won't hold much longer when investors realize what a sham this has been. With Euro, the Yen, and Yuan showing equal signs of weakness and global inflation going into hyper mode, there's really on one save haven and that's GOLD my friends.

    Central banks are probably suppressing the price of gold, using commodity deflation as an excuse. The psychology will change when more US banks become insolvent and the credit crises deepens.... we're not even half through this yet. The credit card crises is next, then the credit default swaps and more bailouts... M3 money supply will increase. If the Fed think they can print more money to get out of this credit crunch, they've got another thing coming!

    For those gold bugs out there, just be patient. Articles that people like Kapur write is nothing but noise.

  • Report this Comment On August 11, 2008, at 9:27 AM, tetonyuma wrote:

    The writer of this piece neglects to mention that gold's fondation today is still as solid in value as it was 5000 years ago, when the U.S. dollar is on the brink of collapse. There are many of us out here that know what a balance sheet is, and can not be fooled by the propoganda given to the public by financial news networks and the government. Gold simply is, it's a reflection of the finacial condition of the country backing the currency in question. The beauty of gold when used in some way to back a currency is it's ability to keep in check man's inherent tendencies toward greed. It simply keeps the books balanced and to keep a hard days wages the same tomarrow as they are today. When I think of gold as an investment, it's only after considering the state of the financial system today, not stacking it up against any investment period in the past. As they say, the past may not be a prolouge to the future.

  • Report this Comment On August 11, 2008, at 1:09 PM, Brettze wrote:

    The only reason gold had been a bummer investment was historically low oil prices that spanned from Reagan term through Clinton term. Many thanks to Jimmy Carter's energy policy or more like automobile policy which required automakers to slash automobile size to meet EPA 's vaunted 27.5 mpg CAFE. The average fleet improved from 14 mpg to 22 or so mpg . The inflationary oil demand plummeted and pushed oil price to $7 a barrel along with a major economic depression in Texas during early 1980's. Gold was stuck with oil prices. Today is a much different world, but we will experience similiar cycle as we already know that EPA will require automakers to raise CAFE to 35 mpg by 2015 or so. The pressure on oil prices from projected falling demand in the coming years is a given. Gold mining firms would do very well to lock in the future prices for next 5 years to keep profits flowing in. I do not really know how long oil prices will remain suppressed as millions will buy fuel sipping models. It is very doubtful that automakers will ever bring back V-8 ever again like the Dusenbergs. It is too excessive except for working PickUps and airport or church-going SUVs that will not be produced in great volumes anyway.

  • Report this Comment On August 11, 2008, at 1:13 PM, Brettze wrote:

    The only reason gold can be decoupled from projected falling oil prices can be new uses for gold in high technology or other kinds of disasters like wars or climate changes.

  • Report this Comment On August 11, 2008, at 5:28 PM, 50yardline wrote:

    Gold is now dropping to $750 an ounce. I would consider pulling the "buy" trigger only at that level.

  • Report this Comment On August 13, 2008, at 7:11 AM, XMFSinchiruna wrote:

    I believe gold's going to $1,650, and Silver to $50 and beyond. I suppose if you held straight through the top of this long-term secular bull market, once the $20 trillion in derivatives have finally de-leveraged and the USD finally bottoms out into a clear technical reversal... if you held through all these events and then for years more to follow... then yes, gold could LOOK like a bad investment. But if you increase your gold allocation during a secular bull market and use discipline and critical independent thinking to determine your exit point/points as the cycle matures, gold will be one of the very best investments available throughout the challenging times ahead.

  • Report this Comment On September 14, 2008, at 11:08 PM, XMFSinchiruna wrote:
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