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 precious 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 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 recent surge in popularity. As usual, investors are chasing performance. But there's more reason to believe that gold is a worthwhile spot for your money these days.

With all the chaos in the marketplace right now and the impending threat of economic doom, the investing herd is thinking "hey, gold is the right option to safeguard your money." And though I agree that gold funds and industry giants such as Goldcorp (NYSE: GG  ) have been on quite a multiyear run, 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 Hewlett-Packard (NYSE: HPQ  ) and Sears (NYSE: SHLD  ) 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. Sad to say, we know this is true now. Titans of our financial markets have dropped like a sack of potatoes in the past few weeks and now -- even once-stodgy companies like Wachovia (NYSE: WB  ) are headed for the guillotine. 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 chemical giant Dupont (NYSE: DD  ) during the height of the Cold War and with the underlying threat of nuclear war? Yet investors that stuck with their guns on Dupont made 2,574% (10.5% annualized) compared to a measly 405% (5.0% annualized) on gold since 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 Morningstars (Nasdaq: MORN  ) and the CarMaxs (NYSE: KMX  ) 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 CarMax -- started small with great ideas on top of cash-generating business models with entrepreneurial owners at the helm. And though the economy may stink right now, this horrible economic situation may actually help the cream of the crop rise to the top of their respective industries and dominate for years to come.

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 14 percentage points on average. Click here to get all of our research and recommendations free for 30 days.

Fool analyst Nick Kapur used to have a gold class ring, but, sadly, lost it. He owns shares of Morningstar. The Fool owns shares of Morningstar, which is a Stock Advisor recommendation. CarMax and Sears are Inside Value recommendations. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (5)

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 September 08, 2008, at 5:21 PM, kurtdabear wrote:

    You need to open your mind up a bit about gold. It's not a long-term hold, but it has a place in any portfolio, just as do many other asset classes. One thing you can be sure of though, is that gold will be worth a whole lot more a year or two from now than Merrill Lynch will (I'm going to miss that firm--I remember when they were Merrill Lynch Pierce Fenner & Beane.).

    But keep in mind that precious metals are important safeguards against unsound money--such as the US$. For instance, in the 1950's it was common to find gas for a quarter a gallon. If you had kept a few of your silver quarters from the '50's and 60's, you could sell them today for roughly enough to still buy yourself a gallon of gas, so until the U.S. government returns to sound fiscal policies, gold is insurance against worthless money. And if you think only nations like Zimbabwe experience hyperinflation, remember that Germany was a world power early in the 20th Century, and all its money was worthless by the early 1920's.

    That having been said, it's up to each individual to decide if he wants physical gold, gold mutual funds, gold ETF's, gold stocks, etc. Physical gold is the truest asset protector, while gold stocks are more like options on the metal. And stocks in any asset class do rise and fall with the success of individual companies.

    Just think of gold the same way you do an umbrella. You don't use your umbrella on sunny days, which are most common in most climes, but it sure is nice to have one when it rains. And if you're in the middle of monsoon season, you might want to carry that umbrella with you for a while.

  • Report this Comment On September 09, 2008, at 12:15 PM, none0such wrote:

    Technically, an investment must yield something - it creates wealth like an education or a factory. Gold is better understood as speculation - a zero-sum game since it doesn't create wealth. However, the previous poster is right. Gold does have a place in a portfolio just as fine art does or antique instruments or other collectibles. The problem with gold is that you can theoretically always extract more as the price climbs whereas there are only so many Whistler paintings. Most companies like to display their tangible treasure-like investments anyhow.

  • Report this Comment On September 09, 2008, at 12:29 PM, afarrell1 wrote:

    Gold is not an investment, it's a store of wealth. Normally, if you think you're in a bear market, you'd keep your money in cash until the storm blows over. Right now, however, there is very good reason to believe that the value of cash will be eaten up by inflation WHILE the storm is blowing over. This is why it makes sense to buy gold. Arguments against gold as an investment miss the point, the same arguments could be made against cash. Warren Buffet, however, has "invested" almost exclusively in cash over the last 5 years or so, for the simple reason that he couldn't find anything worth buying. Gold is no more a long term investment strategy than cash is, but there are times when it is the right, and possibly the only thing that makes sense.

  • Report this Comment On September 09, 2008, at 12:30 PM, afarrell1 wrote:

    Gold is not an investment, it's a store of wealth. Normally, if you think you're in a bear market, you'd keep your money in cash until the storm blows over. Right now, however, there is very good reason to believe that the value of cash will be eaten up by inflation WHILE the storm is blowing over. This is why it makes sense to buy gold. Arguments against gold as an investment miss the point, the same arguments could be made against cash. Warren Buffet, however, has "invested" almost exclusively in cash over the last 5 years or so, for the simple reason that he couldn't find anything worth buying. Gold is no more a long term investment strategy than cash is, but there are times when it is the right, and possibly the only thing that makes sense.

  • Report this Comment On September 14, 2008, at 11:06 PM, XMFSinchiruna wrote:
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