Merrill Lynch has revealed that some of its richest clients are so alarmed by the state of the financial system and signs of political instability around the world that they are now insisting on the purchase of gold bars, shunning derivatives or “paper” proxies.

Rich investors are spurning gold exchange traded funds in favour of krugerrands.

Gary Dugan, the chief investment officer for the US bank, said there has been a remarkable change in sentiment. “People are genuinely worried about what the world is going to look like in 2009. It is amazing how many clients want physical gold, not ETFs,” he said, referring to exchange trade funds listed in London, New York, and other bourses.

“They are so worried they want a portable asset in their house. I never thought I would be getting calls from clients saying they want a box of krugerrands,” he said.  

Gold is in the news a lot these days.  Occasionally someone asks me if they should buy gold.  The response that I inevitably have, as with all such questions, is what are your goals?  If their goal is a quick trade because they think gold is going to increase in value, I tell them not to do it.  If their goal is protection against the dollar collapsing, that is a different story. 

Gold is not an investment.  Please repeat this three times and right it down so that you do not forget it.  Gold is insurance.  It is insurance against a financial apocalypse in your home country.  Ask people in Zimbabwe if they would prefer having their savings in Zimbabwean dollars or gold.  Or, if history is your thing, look at the history of the German mark during the, newly fashionable to talk about, Weimar Republic.  Sometimes governments lose control of their currencies and all hell brakes loose. 

There is increasing concern about that possibility amongst the savers in the world given the ongoing currency brinksmanship we are witnessing.  The savers of the world see the increasing loads of debt that countries across the globe are issuing and see the increasing amount of paper currency being created.  The odds of a major currency collapsing have risen and the idea of having all your money in rubles, euros or dollars suddenly seems less appealing.

Which gets us back to gold.  Owning gold is about possessing a store of wealth that is recognized and tradable all over the world.  If economic disaster or war ravages your home country, gold is a handy tool for bribing corrupt officials to get an exit visa, paying the fare for you and your family to catch the last boat or flight to some relatively safe nation and using the remainder as seed money to start a new life.

If you decide that you would like to buy a little insurance for your family, make sure you do it the right way: take physical possession of the gold you purchase.  In times of great financial strain, some genius in the government inevitably decides that it is the people’s patriotic duty to donate their gold to the government followed by the outlawing of private ownership of gold.  In that scenario the mandarin’s fondest hope must be that all the private owners of gold have conveniently stored their gold in a single place under the stewardship of some ETF.  I do not envy the head of a family who thinks he has protected his family against a collapse in the dollar only to receive a statement in the mail saying, “Due to unprecedented circumstances, the US government has taken ownership of all the gold in the GLD vault and has replaced it with 30 year US Treasury notes.  GLD will let all investors know the conversion rate of gold to Treasuries as soon as that information is shared with us.  We apologize for any inconvenience this may cause you.” 

My mother picked me up from the airport and proceeded to drop a bomb on me – my father is retiring. He is closing his office to become a full-time gardener, online chess player and WWII scholar. This discussion inevitably wound and wended to investments and sound financial planning.

My family has historically been poor financial managers. They typically hold too much cash and often resort to stock picking rather than leaving that up to the professionals. We were discussing the last time my mother had taken an active role in the family’s finances and that was back in 1999. She had been swept up in the mania (who wasn’t besides Warren Buffet) and bought shares of Amazon, Yahoo, Go.com and a few others. The ones that are still in business are still sitting in her portfolio – at a mere fraction of her purchase price. I asked why she hadn’t sold. Her response is interesting for two reasons. She said that she didn’t want to sell because she had lost so much and wanted the stocks to go back up before she sold. She also explained that she had bought quality companies and not silly dot coms.

Her first comment, regarding her desire to avoid turning a paper loss in to a realized loss, is fascinating and one worth of reams of academic and financial discourse – but I will leave all that for another article and when I do, remind me to give all of you my elevator analogy.

The notion of buying quality assets versus ‘fad’ assets is an interesting distinction. This difference is especially relevant right now whilst we are in the midst of a housing bubble [only in certain markets – without this disclaimer, Seneca Spade starts foaming at the mouth] because I keep hearing that the main contrast between the dot com boom and subsequent bust and the housing boom and future bust is that there is real value in homes that isn’t present in stock certificates. Investors make a distinction between assets that have fundamental strength from ones that don’t. This is of course true. But it is not the whole truth.

There are many components to any investment, but the two largest are the asset and The Price. So often, people do not take in to account the price they are paying for something. In the equity markets, one hears comments like, “Intel is a horse of a company and will be around forever.” In real estate I hear things like, “coastal properties in Del Mar are irreplaceable.” You even hear it in consumer purchases “car X is extremely well built” or “company Y makes the best sounds systems.” All of these comments may in fact be true – but that shouldn’t complete the investment decision making process. There is still the question of the price you are paying for those assets and of course the price for competitive or similar assets. Let me give you two thought questions – Is the Nissan Pathfinder a good SUV? I assume that generally the answer is yes. Nissan makes good cars and trucks (one can check consumer reports or Kelly Blue Book) and further, their Pathfinder has been successful for many years. So in terms of the arguments above, we should buy it. Now, would we buy it if the price tag were $350,000? Probably not. Price is important.

This is a good time for a brief discourse on market efficiency and the glories of competition. In terms of equities, many argue that whatever price a company is trading for is probably the correct price. Their reasoning for this being true is as follows; the equity markets are extremely efficient. You have many informed buyers and sellers trading very liquid securities with prices quoted after every trade. This combination allows for investors to adjust their portfolios almost at anytime with little cost to doing so. So when news comes out, rational investors buy or sell shares affected by that news immediately. Or in other words, stock prices reflect all the current, publicly available information about a company and further, they also include everyone’s predictions for the future of that company.

Similarly, with consumer goods, competition forces prices to fall somewhat inline with values. The reason that Panasonic can’t charge $123,566.99 for a television is that we can substitute other similar TVs for the Panasonic and thus Panasonic is forced to price their television somewhat close to its competitors.

Now you can see where I am going with this – real estate, or specifically, residential real estate doesn’t really have the two previous qualities. Real Estate is a much less efficient market than the equity markets and the ability to substitute is severely diminished.

It just isn’t that efficient. There are relatively few trades, [how many homes in your neighborhood sell in a month? Microsoft shares trade about 70 million times per day]. The prices aren’t always disclosed. When they are disclosed, they are often wrong, often include special deal terms that are hard to value (seller threw in some furniture, buyer accepted a questionable termite report, seller cleaned the carpets…) and are often weeks or months old. In addition to information being somewhat spotty, trading has many frictional costs. When one sells a stock one pays $19 when one sells a house, one pays 6% (median priced homes in San Diego are around $500g so that is $30g).

It is also hard to substitute. Every home and piece of property is unique. No two lots are the same. One is closer to the intersection, one gets better light, one has better views, one has more mosquitoes. Compare that with two JVC stereos or two shares of Philip Morris. Real Estate doesn’t lend itself well to substitution.

What this means is that real estate prices and specifically residential real estate prices do not approximate the value of the underlying asset nearly as well as in the equities markets or even the super markets. So what does this mean to you? It means that in real estate the question of pricing is all the more critical. Always ask yourself, is this asset a good asset, but also, ask yourself if it is priced appropriately.

I explained all of this to my mother. She said she understood. And then she said that maybe she should sell her old dot com stocks and buy the apartment building for sale on Montana (street near the old homestead). I asked why. She said “Montana seems like a great neighborhood.”

Your retirement is not the conquest of New Spain.  All or nothing plays, though they can be wildly successful and can lead to conquistador like splendor, are not the kinds of risks you should be taking with your future.  Putting all of your savings into a single speculative venture should be reserved for situations when there is truly nothing to lose.   

When investing for the future you should take a much longer view of things.  You should understand that the economy undergoes boom and bust cycles, fads come and go and sometimes you just plain get unlucky.  To combat the vicissitudes of fortune you must diversify your investment holdings.

A lot of people go about their savings in a very simple way: they have their employer take money out of their paycheck and put it in a 401(k) plan.  This is a good, tax advantaged way to save.  The problem often comes, however, when the employee falls prey to the employer’s siren song of re-investing in the company.  Perhaps the company has been doing well lately and the employee is bullish on the future success of the company.  He or she then goes ahead and contributes 100% of his 401(k) to purchasing company stock.  That is a potentially disastrous decision.

Most people’s livelihoods are not well diversified.  For the most part people rely on their employer for their future well being.  Your employer supplies your paycheck, you are counting on your employer for wage increases and you may also be expecting a nice little pension when you retire.  That is already a lot of eggs in one basket.  Companies fail suddenly, layoffs occur and you do not always have the meteoric rise in your career that you might hope for. 

To subject your savings to the fortunes of the company that you already are so dependent upon is something you should do only after careful consideration of all the alternatives.  It might be the right thing to do, but you are taking on a lot of risk in doing it.

So if you aren’t doubling down on your company’s future, what should you be doing with your retirement savings?  The answer obviously depends on where you are in your life.  When you are younger you can take a few more risks in life.  Your portfolio should be weighted towards slightly riskier assets rather than stable, income producing assets.  As you get older the mix should change until you reach a point in life where, finally, your portfolio consists of mostly income producing assets.

This is not carte blanche to go on a wild stock-picking adventure with your retirement money while you are young.  You should leave that to the pros.  There are people who dedicate their lives to learning the art of investing.  These people study The Intelligent Investor like it was a bible.  They pore over annual reports and study where Warren Buffet went to lunch that day in an attempt to glean a precious new piece of information.  If this profile does not sound like you, stay away from stock-picking.  Even the pros have a hard time beating the market and they have advantages that you can never hope to have on your side. 

Sure you can gamble a little bit of money on that hot stock your cousin told you about, but think of it the same way as putting a pile of money on red at the roulette table: odds are you are going to lose your money, but, hell, you might get lucky and win.

For proper long term planning, concentrate on finding a mutual fund that has a nice track record, low fees and a good rating from a reputable publication like Morningstar.  If you want to make a bet on the growth of America, buy an S&P 500 index fund.  For a little extra diversity, maybe research an international or emerging markets fund and put some money there.  As long as you stay away from French companies, you should be fine.