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By John Maxfield / The Motley Fool
December 22, 2015
A gold bar
Caspar Benson—Getty Images/fStop

As a general rule, gold is not a good investment.

It doesn't earn income. And because it doesn't earn income, it doesn't benefit from the law of compounding returns -- what Albert Einstein once called the "eighth wonder of the world."

The magic of compounding returns

Returns that compound are an investor's biggest ally. They transform ordinary gains into spectacular ones.

Let's assume, for instance, that Jack spends $100 to buy one share of a fictional company that earns and distributes $10 per share a year selling banana smoothies.

If Jack uses the $10 annual dividend to buy accessories for his 1994 Ford Explorer -- as opposed to reinvesting the money and allowing it to compound -- he'll earn $300 over 30 years.

That equates to a 300% return.

This isn't horrible, but it pales in comparison to the 1,654% return earned by Jack's brother, Henry, who reinvests the annual dividends into additional shares of the company.

Chart by author.

By harnessing past earnings to generate future earnings, Henry has engaged the power of compounding, which increases the size of his return each year.

After three decades, Henry will own 17.5 shares that generate $175 in annual dividends. By contrast, his brother, Jack, will still own only one share earning the same $10 a year.

The problem with gold, in turn, is that it doesn't allow investors to benefit from this magic.

As a nonproductive asset -- one that doesn't produce income -- even a prudent and patient investor like Henry can't use it to tap into the law of compounding returns.

The siren song of gold

To be fair, there are times when gold outperforms income-generating assets such as stocks and bonds.

In the late 1970s, rapid inflation increased the demand for gold, which is believed to be an effective store of value. This fueled a rise in gold prices from $400 an ounce in 1976 up to $1,500 an ounce four years later.

The same thing happened during the financial crisis of 2008-09, during which investors fled stocks in favor of gold and other, presumably safer types of investments. The added demand caused the price of gold to increase from less than $400 an ounce in 2000 to more than $1,600 an ounce 10 years later.

Data Source: Federal Reserve Bank of St. Louis. Chart by author.

But the problem in both of these cases is that the price of gold soon dropped as quickly as it had formerly climbed.

It was less than $600 an ounce by 1985. And since peaking in 2011, gold has lost more than a third of its value.

To benefit from these fluctuations, then, an investor would have to time the market -- something we know to be dangerous, if not impossible, for the average investor to do successfully.

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