Gold, and Why So Many Investors Fall for Bubbles
Gold, the asset investors bought to protect their wealth, is down 36% in the last two years. The popular SPDR Gold Trust ETF is down 21% in the last three months alone. What happened?
Business Insider obtained a letter to investors from a fund manager whose fund lost almost 70% in the second quarter -- ostensibly because of heavy exposure to the metal. The manager explained why he missed the plunge:
Here is the problem. The oldest daily gold stock index started in December 1983. If you look at the older, weekly gold stock data, which starts in December 1938, there were plenty of instances when the 1-month RSI readings went lower than February 20 and gold stocks continued to go lower.
While one may think that 29 years would produce enough data to make for a robust indicator, the problem is commodities have 30 year cycles. The last major commodity top was in 1980. So the 1983 data does not even cover a full commodity cycle. While this seems obvious in retrospect, it did not become glaring obvious that something was amiss until the precious metals complex crashed in mid-April ...
In summary, there were many indicators based on 1983 data in February, March and early April that were at all-time extremes. This made the risk look negligible. However, the 1938 data does not give up "all-time" extremes so easily. The next time around the oldest available data will be utilized.
Simple stuff, really. The manager relied on a truncated set of historical data that left out the last bear market to convince him that, historically, gold does really well. Now he's looking at a longer set of historical data and realizing otherwise.
Haven't we seen this before?
Yes. Relying on incomplete data to influence long-term views is also what took down stock investors in 2000, real estate investors in 2006, and Wall Street traders in 2008. Every bubble, basically.
Take this quote from Maggie Mahar's book "Bull!", describing stock investors' perception of market history in the 1990s:
Sometimes a magazine would print what looked like a lengthy timeline unfolding across the bottom of two pages. But closer inspection would reveal that it tracked the market for, perhaps, three years. Occasionally, a story included a chart that looked back to the sixties, but for the most part, a timeline meant to show the market's history went no further back than 1982 -- leaving the bull market in splendid isolation.
Or this, from former Fed chairman Alan Greenspan on what took Wall Street down:
The data input into the risk-management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.
Or this explanation of why a Wall Street risk metric called value at risk (VAR) missed the financial crisis:
All the triple-A-rated mortgage-backed securities churned out by Wall Street firms and that turned out to be little more than junk? VaR didn't see the risk because it generally relied on a two-year data history.
Or this, from testimony by Deven Sharma of Standard & Poor's explaining to Congress why the rating agencies missed the housing bubble:
While we performed analysis in good faith, events have shown that the historical data we used in our analysis significantly underestimated the severity of what subsequently occurred.
During every bubble, investors truncate historical data to build a model that shows them exactly what they want to see: low risk and big returns. You can't blame them. As Nate Silver once wrote, "Human beings have an extraordinary capacity to ignore risks that threaten their livelihood, as though this will make them go away." When you want to believe something, you'll do what is necessary to convince yourself that it's true. Like ignoring historical data that gets in the way.
There's a simpler explanation for what's going on in gold. For years, we had 2% inflation and 20%-plus surges in the price of gold. Now those figures are reverting back toward each other. Which is what a long look at history tells us they were bound to do.
To paraphrase Mark Twain's saying: History doesn't repeat itself, but it rhymes.
The article Gold, and Why So Many Investors Fall for Bubbles originally appeared on Fool.com.
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