Are You Rushing Into Gold?

Too often, investors base decisions on emotions rather than facts.

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When I was in business school in the late ‘70s, the professors taught us that people are rational creatures. They seek to maximize the benefit of any transaction, from buying a soda to getting married. This assumption leads us to the efficient market theory, which says that prices, particularly for stocks, bonds, and commodities must be fair and accurate because they reflect everything people know about them.

In fact, a study from UCLA in the 1980s showed that the price of orange juice futures was a more accurate predictor of the weather in Florida than the actual weather report. It seems that people who bet real money on how the Florida weather will affect the orange crop did a better job sifting through the information and making a prediction than the weather experts who consulted their computers and their maps.

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We might say the same about the stock market, or the real estate market or the commodities market. Maybe these markets predict the future direction of the economy better than the Federal Reserve or the Bureau of Economic Statistics. When people put their own money on the line, they pay more attention, examine the data more carefully, and make better decisions.

Or do they?

If people investing in orange juice--or real estate or stocks or commodities--are all that smart, how do you explain the Internet bubble of the late 1990s or the housing bubble of the 2000s?

It turns out, people are not all that rational. They base decisions on emotions rather than facts. They follow the herd. They only believe information that conforms to their own prejudices. Some people are too stupid to pursue their own best economic interests. Some are too proud, some too lazy.

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What else explains why people pay an exorbitant price for a car or a collectible, just to prove they can afford it? That's not rational; that's egotistical. Or what about people's lack of self-control--when they order a third martini, even though they know they shouldn't, or buy yet another pair of shoes when they have no use for them?

Yale University economist Robert Shiller explains the particular irrationality of bubbles by comparing them to a Ponzi scheme. Some people identify a legitimate economic situation. They get in early and make money as other people bid up prices. Eventually prices outrun any economic justification--yet prices keep rising because investors see prices going up, and they assume they will keep going up, so they jump in. When enough people finally realize that the economics don't support the new prices, the bubble bursts, prices plunge, and almost everyone ends up losing money. These bubble prices are not efficient. They are illusory.

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Is gold really the answer to any practical economic situation? Suppose the world really did fall apart. Would gold solve your financial problems? When was the last time you tried to hand over some gold dust at the supermarket checkout counter, or slide a gold bar into the slot at the gas pump? The only way gold would help is if you could sell it to someone else for a higher price.

But consider this. At the beginning of the millennium, gold sold for around $280 an ounce. By the end of 2005 it was going for $500 an ounce. It hit $700 in 2006, $1000 in 2008, $1200 in 2009, $1400 in 2010, and peaked at $1900 earlier this year.

Do you really think you’re getting in early? Do you really think there’s a legitimate economic justification for gold at $1900 an ounce? Or, do you just want to jump in because you’ve seen prices go up and assume they will keep going up?

I know which way I’ll bet.

Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.