There are several reasons why investors may want to add gold to their portfolio. Not only can gold rise in value over time, but it can be a hedge against inflation and can add diversification.

Having said that, gold doesn't fit in to Warren Buffett's investing philosophy. The central investing principle that has allowed Buffett to build Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) into the massive conglomerate it is today excludes gold and most other assets that are considered to be stores of value.

Here's a brief overview of Warren Buffett's investment style, as well as his opinion on gold in particular, which should help paint a clear picture of why you shouldn't expect to see gold bullion in Berkshire's investment portfolio anytime soon.

Warren Buffett speaking to the media.

Image source: The Motley Fool.

The short answer

Warren Buffett doesn't invest in gold. There are three main things Warren Buffett does invest in, both with Berkshire Hathaway's capital and his own money: entire companies, stocks of public companies, and cash equivalents that are waiting to be invested in those two. If you take a look at Berkshire's investment portfolio, you'll find plenty of subsidiary companies and stock investments, but gold is nowhere to be found.

Buffett's three categories of investments

Before we dive into why Warren Buffett doesn't invest in gold, it's important to discuss how Buffett thinks about investments.

Specifically, the Oracle of Omaha groups all available investments into three categories:

  • Currency-denominated investments: This includes things like savings account deposits, money market funds, bonds, and other similar investment types. These are assets that are generally thought of as "safe" by investors.
  • Unproductive assets: This is the category that gold falls into. Essentially, the investment thesis behind unproductive assets is that someone else will be willing to pay more for the asset in the future than you're paying for it today. Other precious metals such as silver and platinum are also examples of unproductive assets, as are collectibles and cryptocurrencies.
  • Productive assets: Not only can productive assets rise in value over time, but they can generate other assets of value along the way. For example, if you own a stock, it can generate dividend income for you, and the stock itself can increase in value over time. In addition to stocks, examples of productive assets are businesses and rental real estate.

Buffett uses currency-denominated investments regularly

Buffett views the first category, currency-denominated investments, as perhaps the riskiest of all. Specifically, while these assets are virtually guaranteed not to lose their value, they also tend to generate minuscule returns. In fact, the returns are so small that they don't even keep up with inflation over time and erode the investor's purchasing power. (However, Buffett isn't opposed to these investments when the interest rates make up for inflation risk – as they did in the early 1980s.)

For example, let's say that you put $10,000 in a savings account paying 1% interest (for simplicity, we'll assume annual compounding). After 30 years, your deposit will be worth $13,478. Not bad for a completely safe investment, right? Wrong. Assuming a long-term inflation rate of 3%, the actual purchasing power of your $13,478 account balance (in today's dollars) will be just $5,404. So while your account balance is slowly increasing, you're actually losing money on a real basis.

Having said all of that, it may surprise you to learn that Warren Buffett uses these types of investments frequently. In fact, $116 billion of Berkshire Hathaway's capital is invested in these currency-denominated investments, such as short-term Treasuries.

Simply put, currency-denominated investments have the advantage of liquidity, meaning that they can be quickly sold at their full market value if necessary. Buffett lets Berkshire's cash accumulate until he finds an attractive investment opportunity, and even the minuscule returns of short-term Treasuries and money market funds are better than nothing at all.

You won't be surprised at Buffett's favorite category

Not surprisingly, Warren Buffett's favorite thing to do with Berkshire Hathaway's capital is to invest in productive assets. Specifically, Buffett's No. 1 preference is to find entire businesses to acquire, and as an alternative, he is willing to invest in the common stocks of other companies. As of April 2018, Berkshire has more than 60 subsidiary companies, as well as a closely followed stock portfolio worth about $176 billion.

Warren Buffett likes assets that create wealth. Gold and other unproductive assets may hold wealth, but they don't create it.

Here's a quick example of a wealth-creating asset. Let's say that you own 1,000 shares of a stock that pays a 4% dividend yield. Over the next 30 years, assuming that you reinvest all of your dividends, your 1,000 shares can turn into 3,240. So, you've more than tripled the size of your investment, before considering any stock price appreciation.

The point is that Warren Buffett invests Berkshire Hathaway's capital in productive assets, and in currency-denominated investments while he's waiting to find more productive assets to buy. He doesn't invest in unproductive assets like gold.

Buffett's opinion of gold

While Buffett isn't a fan of unproductive assets of any kind, he has discussed his reasons for avoiding gold in particular.

In his 2011 letter to Berkshire Hathaway shareholders, Buffett pointed out that gold is a "huge favorite of investors who fear almost all other assets, especially paper money." And to be fair, Buffett acknowledges that investors are right to fear paper money as a store of value, specifically because of inflation.

In regards to gold, Buffett discussed two major shortcomings. Like all unproductive assets, gold is not "procreative." In other words, gold will never produce more gold, or anything else of value, for that matter. In contrast, an oil well Berkshire buys will produce a stream of valuable oil. A clothing factory will churn out clothing for as long as it's in operation. A stock investment can pay dividends, which you can then use to buy even more shares. But an ounce of gold you buy today will still be just an ounce of gold in 400 years.

The second shortcoming Buffett discussed is the lack of much practical use for gold. Sure, it's used to make jewelry and has some other applications, but widespread demand for gold just isn't there. Buffett's point is that unproductive assets with widespread industrial applications, such as copper or steel, can at least rely on this demand to boost prices.

In a 1998 speech at Harvard, Buffett said:

[It] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

Which would you rather own?

To illustrate his point, Buffett used an example of two hypothetical groups of investments. The first group contained all of the world's gold supply, worth about $9.6 trillion at the time Buffett wrote the letter. The second group contained assets of equal value -- all of the crop-producing farmland in the U.S., 16 ExxonMobils, and $1 trillion in working capital. (Note: At the time Buffett wrote the letter, ExxonMobil was the world's most profitable corporation.)

Here's the idea. Not only would these assets increase in value over time, but the farmland would generate $200 billion in annual income, and the 16 ExxonMobils would each produce profits of $40 billion per year, for a total annual production of $840 billion per year, which could then be invested in other productive assets.

In fact, it is this logic of production and reinvestment that has allowed Berkshire Hathaway to grow from a struggling textile manufacturer in the 1960s to one of the world's largest companies today. Suffice it to say that the same wouldn't have happened if Buffett had simply invested Berkshire's capital in gold after he took the helm of the company.

Not a great investment, but...

So, Warren Buffett doesn't invest in gold. However, that doesn't mean that gold and other precious metals don't have a legitimate purpose in a well-rounded portfolio.

Specifically, gold can be useful (in relatively small amounts) as a hedge against inflation and stock market crashes. Gold tends to keep up with inflation -- better than cash, at least -- so during periods of high inflation, gold can help preserve your purchasing power. Furthermore, gold tends to outperform stock during crashes, as investors seek safer assets. For example, the S&P 500 fell by 38% in 2008 when the financial crisis hit, but gold actually gained more than 4% for the year.

The bottom line is that the majority of your portfolio should be invested in productive assets, with some cash and equivalents on the side, waiting to take advantage of attractive investment opportunities in other productive assets that come up. However, there's nothing wrong with investing a small portion of your portfolio in gold or other precious metals in order to protect against inflation and to add diversification.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.