This article is part of our Rising Star Portfolios Series.
Commercials advertise "Cash for Gold," but as I see it, the far smarter move is "Gold for Cash." Cash loses purchasing power dramatically over time, and with a global currency war and sovereign debt crisis just beginning, this threat is heightened. There aren't many liquid money alternatives except gold, and because gold is still very attractive in relation to cash, I think buying gold is the right thing to do. Below, I'll explain further why I'm putting my entire Rising Star Portfolio cash hoard of almost $5,000 into gold. Tomorrow, I'll tell you the safest, most convenient way to do it.
Cash is really government debt
First, I'm not doing this because I want to make money -- gold is money, and who ever got rich buying money? I'm doing this because I want to protect what I have. Today, you've got two choices for money: currencies issued by central banks, or hard assets like gold. Remember that in a debt crisis, debtholders worry about getting their money back. Well, it's a similar situation in a sovereign debt crisis, except that governments that borrow in their own currencies can always pay debtholders back by creating more of it, diluting the existing currency's value. Therefore, by holding cash, you expose yourself to the very real risk of losing significant purchasing power as a sovereign debt crisis unfolds.
But maybe this crisis has made gold expensive while simultaneously putting paper currency on sale. After all, gold is at an all-time high -- but in nominal terms, not in real terms. The market value of the U.S. gold reserve is 4% of M2, the money supply measure that includes cash, checking & savings accounts, money market accounts, and small time deposits. In other words, a very small percentage of dollars are backed by gold. In January 1980, gold peaked at $850, and the reserve represented roughly 15% of the money supply at that time. Valuing gold at 15% of money supply, applied to today's M2 and gold reserve figures, implies a gold price of $5,000 per troy ounce.
Not buying gold is the risk
Given current dynamics, I consider a $5,000 price very likely in the future, so let's look at our upside and downside potential in the next few years. At $5,000, we have $3,600 of upside from the current $1,400 price. My estimate of downside is $1,100, just above where India bought gold from the IMF last year, meaning we're risking $300 ($1,400 minus $1,100). This means we have $3,600 of upside and $300 of downside, a 12:1 ratio. In other words, our initial capital of $1,400 could increase 260% or decrease 20% in nominal terms.
But because our only other choice for money is paper currency, if we don't buy gold, we are risking $3,600 in purchasing power for a potential $300 gain, a 1:12 ratio. This is why your real risk isn't in buying gold, it's in staying in cash, which has an excellent chance of decreasing in relation to gold.
What they don't teach you in business school
The standard argument against gold is that because it doesn't produce income, it can't be valued. I disagree with this statement because valuation at its heart is about predicting the future. For stocks and bonds, this means estimating future cash flows. But if an asset does not have cash flows, you need to fall back to economic fundamentals and predict both supply and demand for that asset in the future.
Consider artwork. Art dealers know how many paintings exist by a particular artist, so supply is easy. They also know how deep demand is -- whether it's a new artist with possibly flaky support or an established name with many buyers who will enter the market should prices fall. This, and a wealth of information gathered in the business, allow them to determine whether a painting is good value or not.
Similarly, with gold, the supply side is easy to determine: it increases by roughly 1% to 2% per year. The tricky part is gauging future demand and how it will change. But it's really not that hard-demand is off the charts. India and China and other emerging powers know they don't have enough gold relative to their reserves and the size of their economies, and they're desperate to diversify away from dollars. The same goes for investors and ordinary folk worried about the ongoing destruction of the dollar.
So instead of income flows, valuation centers on an analysis of supply and demand. Gauging demand may involve different techniques like geopolitics, emergent behavior, and complex system dynamics, but it doesn't mean informed judgments can't be reached on a range of future values for gold. Just like an art dealer can value a piece of art because she is intimately familiar with the supply and demand dynamics that drive prices, you can do the same with gold.
Listen to the professionals
If that's too daunting, here's an easy alternative: listen to the professionals, the gold and silver analysts that have followed metals for years. I do. Not for positive reinforcement, but because they spend all day studying and thinking about precious metals, and consequently understand the dynamics multiple times better than those who haven't done any research. And right now, most of the people who know the most about the sector are overwhelmingly bullish, while many with bearish sentiment know relatively little about gold. There is the risk that tunnel vision can creep into some analyses, but the difference in knowledge and time spent on the subject is in many cases 1,000 to 1, so as I see it, it's a no-brainer to whom you should listen.
Choose the best odds
My $5,000 is sitting in cash and quite frankly, making me nervous. Eventually I plan to allocate it into equities, but at the moment, given the choice of making a 12:1 bet on gold or a 1:12 bet on cash, I'm going for gold. Tomorrow I'll show you a safe, convenient, and low cost way to do so. Hint: It's not SPDR Gold Trust, the most popular exchange traded fund. Tomorrow, I'll tell you why not.
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).
Andrew Sullivan, CFA, owns shares of no companies listed above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.