You should not buy an asset or an asset class, because everyone else is buying it or because it has recently made money

You gotta buy gold!! It recently reached an all-time high. Central banks all over the world are spewing out money. Greece and the rest of the PIIGS countries are going to destroy the euro and its banks! There is going to be a double-dip recession. So the only safe asset to own is gold!
 
No. No it isn't.
 
Let us start with the obvious. Investing and most businesses are based on one principal: buy low, sell high. If you buy an asset, any asset when it is selling at its height, the probability that it will go down far exceeds the probability that it will go up. If you can find a greater fool, who will buy it at a higher price, you might make money, unless it turns out that you yourself are the greater fool. It is far safer to find an asset, or even better an asset class, that is trading at an annual or cyclical low and buy that. Then at least the probabilities are working in your favour.
 
Buying gold right now also violates another cardinal rule of investing. You shouldn't chase returns. You should not follow the herd. You should not buy an asset or an asset class, because everyone else is buying it or because it has recently made money. The idea behind this is based in behavioral economics.
 
The problem with all markets is that neither the players nor the market is rational. As Keynes pointed out, "Markets can remain irrational a lot longer than you and I can remain solvent." Much of the irrational comes from our cognitive biases. A cognitive bias is a pattern of deviation in judgment that occurs in particular situations. We all have cognitive biases. One of the most pernicious is the Bandwagon effect which is the tendency to do (or believe) things, because many other people do (or believe) the same. This is also called herd behaviour.
 
Another one is the neglect of probability which is the tendency to completely disregard probability when making a decision under uncertainty. For example, the belief that since Apple Computer and gold have done very well for the past few years means that they will do well in the future. The best example of course was the US housing boom, when the idea that house prices in the US could go down was never considered. Of course when they did, it was considered an aberration rather than a normal probability.
 
Another reason given for buying gold is that it has become a favourite asset of central banks and Sovereign Wealth Funds (SWFs). According to a poll by UBS at its annual seminar for sovereign institutions, central bank managers believe that gold will be the best-performing asset class in the next six months, ahead of equities, bonds, oil and currencies. This year there have been significant purchases of gold by China, India and Russia. The Chinese SWF, the China Investment Corporation, recently made a small investment in bullion. There are rumours of bullion purchase by the Abu Dhabi Investment Authority and the Government of Singapore Investment Corporation.
 
Of course governments and central bankers have not always been the best investors. Quite the reverse. From 1999 to 2002 the UK sold gold at an average price of $275, basically its 20-year low. They weren't alone. The Reserve Bank of Australia sold two-thirds of its gold reserves in 1997. In addition around the same time the Swiss National Bank sold half of its gold reserves-a very material 1,300 tons. The French, Dutch, Belgians, Swedes, Portuguese and Spanish all did the same. It would be hardly surprising if central banks sold gold at the bottom and bought at the top.
 
Finally there are the economics. Usually people buy gold in times of market stress or inflation. The doubts about sovereign debt do cause market stress at the moment, but it is nowhere near what it was in 2009. At that time gold was almost 30% lower. No one can argue that the central banks are printing money. In normal circumstances such fiscal profligacy would create inflation. Inflation is usually good for gold and bad for debt. But the ten-year treasury bond yields are quite low at just 3.3%. So we have an anomaly. Bonds and gold which are usually inversely correlated are now both doing well.
 
One potential explanation is that while government policy (low rates, quantitative easing, and big deficits) looks inflationary, the economic environment (high unemployment, anemic growth) looks deflationary. So investors are hedging their bets by buying gold and government bonds.
 
But no anomaly lasts forever. In the not too distant future, maybe tomorrow in emerging markets, interest rates will rise. When that occurs, there is a high probability that the herd will change directions.  
 
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).