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January 31, 2007

What A Fool Believes
by Nick Barisheff

I am frequently surprised by the various myths, misconceptions and negative biases that are prevalent among investors, financial advisors and journalists when it comes to the subject of gold. I appreciate that precious metals have not been popular as they have been an underperforming asset class since 1980, and that there has been an incredible bull run in financial assets. However, these trends changed in 2000 and although the Dow Jones Industrial Average has surpassed its previous high it has lost over 50% in gold terms. As these multi-decade trends evolve, it is critical to re-evaluate portfolio holdings, and rebalance them accordingly.

Many investors and their advisors subscribe to the buy-and-hold strategy, believing that equities always go up. They like to refer to the past twenty years as proof that this is the case. However, if you look further back and examine more than just the last cycle, you will likely develop a different viewpoint. Imagine that you were 60 years old in 1968, and quite content with your buy-and-hold philosophy; the previous 20 years were good ones for equities and bonds. But if you stayed with that same strategy for the next 20 years, you would have had a difficult retirement. You would have lost money in bonds, and it would have taken 17 years for your equities just to break even. After taking into account the eroding effects of inflation, the purchasing power of your investments would have suffered substantially. Although eventually the buy-and-hold strategy would have worked, you likely didn't live long enough to make up your losses in the next cycle.

To add insult to injury, you would have also lost out on the tremendous gains generated by precious metals. During the 1970s, gold had returns of 2,300%, silver 2,400%, and platinum 900%. Unfortunately, many investors finally threw in the towel in the late seventies, sold their equities and bought gold just as the cycle was about to turn again.

In order to make the most of your investment portfolio, it is important to re-examine long held beliefs within today's realities and determine if they are still relevant. An article entitled 3 Things to Know Before You Buy Gold, written by Rich Smith and recently published in The Motley Fool, an internet-based investment website, purports to highlight some commonly held myths and misconceptions about gold.

http://www.fool.com/server/printarticle.aspx?file=/investing/small-cap/2007/01/17/3 -things-to-know-before-you-buy-gold.aspx?source=eptyholnk303100

The article criticizes a number of assertions made in an advertisement that recommends buying gold now. While there are many deceptive ads around placed by unscrupulous and, in some cases, fraudulent precious metal dealers, the article deals with a number of fundamental myths about gold.

Myth No. 1: Gold is predicted to go to $1,800 an ounce

I agree that unsubstantiated opinions about future prices of anything are inappropriate; nevertheless, claims like this are made by some in the precious metals business. Bear in mind, however, that an inflation-adjusted high of the 1980 peak gold price - US$850 - results in a gold price of US$2,080 per ounce today. As such, a price prediction of US$1,800 may not be that outrageous.

In the early 1970s no one would have believed that gold could reach $850, or silver $50. The same holds true for the NASDAQ. When the NASDAQ was 165 in 1980, who would have dreamed that it could reach 5,000?

Although it should be a separate myth, Smith also scoffs at the idea that any reputable money manager would advise that 10% to 20% of an investment portfolio should be allocated to gold bullion. This is likely true, since most money managers today are not old enough to have experienced the last bull market in gold, or the 1964-1982 bear market in equities. Their entire investment experience has been confined to one cycle - the biggest and longest-running equity bull market in history. While many of the world's wealthiest families do have substantial gold holdings, most US and Canadian portfolios have no allocation to precious metals whatsoever. Many North American confuse gold bullion and mining stocks, and do not appreciate that bullion is an entirely different asset class with vastly different risk and liquidity characteristics.

And yet the majority of money managers claim to provide their clients with balanced, diversified portfolios, even though those portfolios are limited to stocks, bonds and cash. Since there are seven asset classes in total - stocks, bonds, cash, real estate, commodities, precious metals and collectibles - today's typical investment portfolio is anything but diversified or balanced. Many advisors will be faced with massive law suits when investors suffer losses during this cycle, because they only allocated to declining assets and didn't provide adequate diversification.

Because there is very little information or methodology available to assist in determining what an appropriate allocation to precious metals should be, in 2005 I commissioned a study by Ibbotson Associates. Ibbotson is recognized as a world leader in asset allocation, and bases their work on Harry Markowitz's mean-variance optimization paradigm - the heart of strategic asset allocation. Because gold's economic role changed so drastically following US President Richard Nixon's closing of the gold window in 1971, Ibbotson studied the period from 1970 to 2005. That was as far back as they could go to make meaningful investment comparisons.

Ibbotson reached several conclusions. First, they concluded that precious metals are the most negatively correlated asset class to traditional financial assets and, as a result, they act as a hedge for the entire portfolio. During high inflation periods, precious metals outperformed all asset classes. During periods of stress, they provided returns when they were needed most. During low inflation periods, they provided bond-like returns. Ibbotson found that, based on a strategic asset allocation model, investors could potentially improve reward-to-risk ratios in conservative, moderate and aggressive portfolios with allocations of 7.1%, 12.5% and 15.7% respectively. Their work did not take into account any of the risks posed by rising inflation, rising debt levels, federal budget and current account deficits, rising oil prices, geopolitical tensions or any of the current vulnerabilities and imbalances in the economy.

In addition, studies have been carried out by David Ranson, head of research at Wainwright Economics, with respect to the amount of gold necessary to immunize portfolios during periods of rising inflation. He concluded that, for optimum results, investors need 18% for a bond portfolio, and 47% for an all-equities portfolio.

From a tactical asset allocation point of view, a portfolio's allocation to bullion should be much higher in today's economic climate. Tactical allocations should be adjusted to the directional trend of the Dow:gold ratio in order to maximize returns. When the ratio is rising, as it was from 1920-1929, 1945-1965, and 1980-2000, portfolios should be overweight financial assets. When the ratio is falling, as it was from 1929-1945, 1965-1980 and 2000 on, portfolios should be overweight precious metals.

On August 15, 1971 the Dow was 856 while gold was $35 per ounce, for a Dow:gold ratio of 24:1. By January 21, 1980 gold had risen to a peak of $850 per ounce while the Dow stood at 872, for a Dow:gold ratio of 1:1. At this point the cycle changed and the Dow:gold ratio rose until it peaked at 44:1 in 2000. It has been dropping ever since, and now stands at 19:1. Many specialists in cyclical trend analysis believe that, at the end of this cycle, the ratio will again be 1:1.

Myth No. 2: Gold performance vs. common stocks

Smith contends that while gold has increased by about 3,159% since 1926, it has only generated 4.5% annually. Stocks, on the other hand, generated a return that was a one percentage point higher. I'm not sure it would be worth putting your gold at risk to earn an additional return of only 1%. More importantly, this type of comparison shows a complete ignorance of monetary history. The US was on a gold standard until 1971 and consequently it is useless to make investment comparisons prior to that time. Until 1971, gold was regarded as money and the price was fixed at $35 per ounce. Today, many investors and money managers ignore 3,000 years of monetary history and mistakenly believe that gold is just another commodity, like pork bellies or copper.

Even though the comparison is inappropriate, if you were to measure from 1971 to today, and adjust for inflation, gold has increased about 250% in real terms vs. the Dow's 180%. From 1971 to 1996, gold outperformed the Dow on a cumulative basis. The Dow outperformed gold between 1996 and 2003, but since 2003 gold has again been outperforming the Dow. Even though the Dow has recently surpassed its 2000 highs, it has lost nearly 50% relative to gold.

Myth No. 3: Gold is forever

Smith claims that the value of $1 invested in gold in 1802 has declined 2% as supply increased, while $1 invested in stocks has increased 600,000 times. My previous point regarding gold as money with a fixed price until 1971 applies. Money must be evaluated or compared on the basis of its foreign exchange value, or its purchasing power. While the US was on the gold standard, inflation was kept in check and the dollar maintained its purchasing power and foreign exchange value. Since 1971, when Nixon closed the gold window, the US dollar has lost about 80% of its purchasing power. Since its peak in 2001, the US dollar index has lost about 31% of its foreign exchange value. Gold, however, has not only maintained but increased its purchasing power, while its foreign exchange value has risen in virtually all currencies. It takes fewer ounces of gold to buy a house, a car, the Dow, or almost any other good or service than it did in 1971. Gold will continue to increase in purchasing power as long as its inflation rate (mine supply) is lower than the increase in the money supply. Mine supply increases by about 1.5% annually, but has recently started to decline because new sources are becoming more and more difficult to find. In sharp contrast to gold "inflation", most central banks are now increasing money supply at double-digit rates.

As evidenced by the recent NASDAQ bubble, stocks can be created almost without limit. How many of the stocks that were available in 1802 are still around today? Unless you were an expert trader, your portfolio of 1802 stocks would now be zero. You can replace a stock within an index and continue charting the theoretical returns, but the investor's original investment is gone and can't be replaced unless they were astute enough to sell at the right time. Of the 30 original stocks that made up the Dow in 1929, only two are still there today.

Gold bullion is, in fact, forever, because it is not someone else's promise of performance or someone else's liability, as are financial assets like stocks and bonds. Promises can be broken and liabilities defaulted. Neither the stock or bond holder in Enron salvaged any part of their investment. Gold, silver and platinum bullion cannot decline to zero and they cannot be created at will by central bankers or governments. They will retain their value when many of today's stocks are nothing more than a distant memory.

Nick Barisheff
Bullion Management Services Inc.

Nick Barisheff is President and CEO of Bullion Management Group Inc., a bullion investment company that provides investors with a cost-effective, convenient way to purchase and store physical bullion. Widely recognized in North America as a bullion expert, Barisheff is an author, speaker and financial commentator on bullion and current market trends. For more information on Bullion Management Group Inc., BMG BullionFund and BMG BullionBars visit: www.bmginc.ca.

The opinions, estimates and projections stated are those of the author as of the date hereof and are subject to change without notice. The author has made every effort to ensure that the contents have been compiled or derived from sources believed to be reliable and contain information and opinions, which are accurate and complete. Neither Nick Barisheff, nor Bullion Management Group Inc. or any of its affiliates take responsibility for errors or omissions which may be contained therein. Neither the information nor any opinion expressed herein constitutes a solicitation for the sale or purchase of securities, and investors are encouraged to seek advice from a qualified investment advisor before making any investment decisions.

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