Confused About Gold and the Dollar? Understand Their Relationship Before You Invest

It’s not known for sure where the concept that an ounce of gold could always buy a nice businessman’s suit came from, but the analogy is used today by many who want to paint a positive picture for gold.  The premise of the story is used to reveal the fact that the dollar has lost 95%-98% of its purchasing power since the creation of the Federal Reserve in 1913.

The typical story goes something like this:

“In the early 1900’s an ounce of gold was worth $20.00 and could buy a nice men’s suit. During that time an ounce of gold was worth $20.Today an ounce of gold is worth around $960.00 and can still buy a very nice men’s suit whereas $20 might get you a necktie.”

But how much of the story is fact, and how much is fiction?  Are we really comparing apples to apples when we use this analogy of the price of a businessman’s suit and the price of an ounce of gold both then and now?

There’s the assumption that the $20 cash just sat there earning nothing.Is this what a person did back in the beginning of the 20^th century?Who in their right mind would do this?  Would you do it today?  Today’s investor is always trying to have their money earn more money.  In the 20’s, they did the same.

The parable assumes that people did in fact take the $20 and put it under their mattress.

My grandmother was from that era and one of those who feared losing money.When she passed away in the 90’s, we found some old birthday cards that she had received with the $10’s and $20’s still stuck in the card.But she probably didn’t want to lose money in the stock market, so kept it from her husband who liked to dabble.Her husband, my grandfather, like many in the 20^th century, did like to play the stock market or put their money in bonds or a bank where it could earn interest.

They called it the roaring 20’s for a reason and the stock market was doing well and so were the banks.

But the stock market crashed in 1929 and the thousands of banks failed soon thereafter.  In 1933, gold was even confiscated.

So stocks, bonds, dollars and gold all had their problems, but for the sake of argument, let’s ignore the various problems of that era and deal with what’s happened since that time with gold, bonds and stocks.

While it is true that the purchasing power of gold in and of itself has kept pace with inflation over the years, the dollar in and of itself has not.  But the dollar does offer the investor something that gold doesn’t, and that is interest.

Gold does not offer the investor any interest while the dollar that is put in the bank offers the depositor a return on their deposit.Bonds and some stocks offer interest (dividends) as well.

The bank offered a depositor interest on their savings account and this is what normal people did back in the 1920’s.This accumulated interest is what the price of an ounce of gold should be compared to today.

So to do apples to apples historical comparison, one has to measure the value of one investment that they held at that point in time versus the other based on what a rational, reasonable investor would do.

Naturally, you would agree, a rational investor would not put the $20 under their mattress back in the 1920’s just as they wouldn’t today (emphasis on the word rational here).  On a side note, I’ll also leave out of this analysis the fact that the businessman’s suit bought in the 20’s, today would be rather old and musty and more than likely didn’t retain its purchasing power and I’ll also leave out the fact that those folks who put their dollars under the mattress back then would get a decent amount for them today from collectors if they were kept in good condition.

The Historic Analysis of Gold vs. the Dollar

Since we already know the price of gold today, we need to go back and calculate the interest paid on dollars and bonds from that period of time to today.  I’ve also included a comparison to stocks.

I picked the year 1929 to do my calculation.  Gold was priced about $20 an ounce1 then and had been holding steady at that price for years.

The dollar had not yet depreciated by 60% with the revaluing of gold to $35 an ounce in 1934, so in a sense, I’m allowing for the fact that the price of gold was artificially moved higher and the dollar was knocked down a peg or two.This depreciation of the dollar didn’t help most as they were not allowed to own gold at the time.It only helped the government and the Federal Reserve, but that’s a story for another time.

So to find the interest earned from 1929 to 2008, I turned to this2 website and used the “short term”3 rates as my guide.4Keep in mind I’m not using CD rates5 which have actually averaged 1.1% higher than short term rates over the last 10 years, but I did analyze long term bond rates6

Compounding the data, the $20 would have grown to $393.86 in the short-term asset account and $1,904.23 in the long-term asset (at a term of one year’s account) by the year 2008.7The Dow Jones Average would have returned you $562 (before dividends).8

These figures you can then compare to the current price of gold at $981.751

You can see from this analysis that the gold price historically fits somewhere between a short term savings account and a long term “one year bond” account.Gold has performed 42% better than the DOW during this time-frame.

So if someone put all their money each year into short-term asset accounts, they wouldn’t be able to buy the same businessman’s suit as they could if they had put it in gold, but they’d still be able to buy a decent suit at Men’s Warehouse but not what $981 could buy you at Brooks Brothers.

Either way, it’s a bit of a false conclusion comparing what a $20 ounce of gold can buy in 1929 versus what $20 cash can buy today.There has been a benefit of compounding interest one has received on that $20 put in the bank over the years.  There is also the fact that the dollar still had gold backing for 42 years of this analysis until Nixon took the U.S. off the gold standard.

Now the Good News Concerning Gold…

Let’s take a look at the dollar’s performance after Nixon took the U.S. off the gold standard in August of 1971.  The price of gold in August of 1971 averaged 42.73 an ounce.

What have the interest bearing savings accounts and long-term one year asset bonds earned versus gold during this 1971-2008 time-frame?

Beginning with $42.73 in 1971, the short-term savings account would have returned you $350.87 while the long-term one year asset would have returned you $832.93.The Dow Jones Industrial Average return would have been $425.34, again without dividends, but keep in mind that stocks since 1971 weren’t paying anywhere near the dividends like they had been).

You will notice that the difference between the short-term savings account compounded from 1929 to 2008 isn’t much different than the 1971 to 2008 figure, about $43.00.Why is this?….because for 42 years, up until 1971, gold backed the dollar. At that time, gold and the dollar were perceived as equivalents.So since 1971 interest rates have had to rise to keep pace with the loss of purchasing power of the dollar.The problem is they haven’t.

Not even the glorious stock market has kept pace with gold yet this is where most people invest their money.Long term bonds have held their own, but are now weakening compared to the price of gold.

Bottom line:Gold is breaking free!

The Great Decoupling of Gold from the Dollar

What you are seeing folks is the decoupling of gold from the dollar, short and long term bonds as well as stocks.  Since 1971, gold has outperformed cash, stocks and bonds, yet you never see your financial adviser, sans a few, recommend gold as an investment.  Why is that?

The answer is simply they can’t make any money selling it…so they don’t, plus the fact they don’t understand it.Most people don’t understand gold as an investment or how it fits into one’s portfolio.

Gold needs to be a part of every person’s portfolio.  Gold is insurance as the dollar falls.Gold is the wealth you need to pay for things.Gold used to back the dollar.Now it has decoupled from it.

If you would like to know more about investing in gold, read my free White Paper, “How Gold Investments Can Secure Your Retirement Years.”

1 http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx (Click on Historical Charts for gold)

2 See actual year by year interest rates by inputting the years 1929 and 2007.They had only calculated through the year 2007 by the time of this writing.

3 Short-term (similar to a savings account at a bank): assumes that the principal investment is made in equal installments throughout the initial year at the average short-term rate for that year. The principal plus the interest accumulated is then reinvested at the average short-term rate for the second year. This continues until the final year, when the withdrawal is assumed to be made over equal installments throughout that year.

4 I calculated the year 2008 by using the short term rate of 3% and for the five months ending May 31^st, 2009 I utilized a rate of 1.5%.

5 CD Rates Last 10 years; http://www.jumbocdinvestments.com/historicalcdrates.htm

6 Long-term (assumes a government or corporate bond): assumes that the principal investment is made in equal installments throughout the initial year at the average long-term rate for that year. The principal plus the interest accumulated is reinvested at that same rate for the second year, and continues at that rate for the number of years of the term you have selected. At this point, the calculator will use the long-term rate of the next year and repeat the process. This continues until the final year, when the withdrawal is again assumed to be made over equal installments.

7I used 1.83% for 2008 one year Government bond and .56% for the average of 5 months ended 5/31/09. Source: http://www.federalreserve.gov/releases/h15/data.htm

8 Keep in mind that taxes are not taken into account in this analysis as tax rates have varied over time for both income and capital gains.  Tax deferred annuities could have been utilized in the analysis with gold where the accumulated value withdrawn at the end of 2008 would result in a combined federal and state tax rate close to 50% (depending on your state) while the sale of gold would result in a 28% tax on the capital gain.If one was taxed all along in the short-term and long-term account, the effective rate would be about 60% on average for the top tax bracket and possibly 15% or no tax for the lower tax brackets.  There are too many variables involved, so I have just compared each asset with no tax ramifications.