A Billion-Dollar Misunderstanding (in Gold)

Investing in gold isn’t likely to protect you from inflation or economic collapse.

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There are small misunderstandings, like the one chronicled by Robert Grover in his cult book, “One Hundred Dollar Misunderstanding”. Then there are really big ones.

The miscalculation by hedge fund gurus John Paulson and David Einhorn relating to the price of gold falls into the latter category. According to an article in Forbes, Paulson had a paper loss of around $1.4 billion on his gold investment this year, although he still has a gain since he created the gold share class for his hedge fund in 2009 when gold was selling at $950 an ounce.

David Einhorn, who runs hedge funds (including a dedicated gold fund) at Greenlight Capital Management, also bet heavily on gold. According to Reuters, Einhorn’s investment in gold was recently listed as its third largest position in its main fund.

Paulson and Einhorn were not alone in their gold bets. Former congressman Ron Paul was reported to hold 64 percent of his assets in precious metal stocks. Those stocks have lost more than 40 percent of their value.

It has long been my view that investors who overweight their portfolios in gold are engaging in flawed thinking. Many are motivated by a doomsday scenario based on their view of the imminent collapse of the world’s economies. They don’t understand that the price of gold, at any point in time, takes into consideration all publicly available data. There’s nothing you know about the likelihood of a default in the sovereign debt of Greece, the potential collapse of the Euro or the slowing of the economy in China that is not known to the millions of traders who buy and sell gold every day. These traders set the price of gold with every trade. That price is likely to be a fair price. If you are buying gold in the belief that it is mispriced, you are most likely mistaken.

While you are holding gold, it is not paying any dividends or engaging in any productive activity (like manufacturing goods or providing services). Your investment is premised on the assumption that there will come a time when you can sell your gold for more than you paid. Of course, that is the same assumption the investor who sold gold to you was making.

My colleague Larry Swedroe made some prescient observations about investing in gold in September 2009. He noted that gold has provided virtually no real return over the very long term. For those who seek a hedge against inflation, Swedroe believes TIPS and short-term Treasury bills are “far superior.”

If you invested in gold recently, you were probably comforted by the fact you were in good company. Paulson and Einhorn are two of the best known hedge fund managers in the country. Both made their reputations based on their hugely successful bets against subprime mortgage debt during the financial crisis. Less widely publicized is their more recent performance. In 2012, Greenlight Capital underperformed the S&P 500 Index, returning only 8 percent compared to 13 percent for the index. Paulson’s 2012 performance was worse. On average, his five funds had returns of only 1 percent. One of his largest funds, The Advantage Fund, had losses of 14 percent.

If your investing strategy is based on a belief that hedge fund managers have special insights into the price of gold—or investing generally—your confidence is misplaced. Your misunderstanding could cost you a lot more than one hundred dollars.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.