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Tuesday 6 March 2012

Salience is Golden

New Frames

As so often in the past Warren Buffett has stirred up a swarm of annoyed investors, this time by explaining why he thinks gold as an asset class isn’t so much overvalued as irrelevant. He’s done this in a way typical of the man, by changing our frame of reference, to give us an entirely new perspective on the issue.

This gives us an insight not just into gold's current status as an investment class but also into why Buffett is almost unique as an investment guru. He doesn’t rely on the old arguments about what’s important by drawing on existing ideas of what’s salient, but develops new ones, based on his own models. He changes what’s salient, and that’s real gold for investors.

Classic Arguments

We’ve all heard the old arguments about why gold is such an important asset. Hell, I’ve even used them myself (see: Gold!). Over periods of hundreds of years it’s held its value against fiat money, it’s the place where people go when they’re frightened, and unsure of the future.  Also they're not making it any more, and when demand goes up against a limited supply the consequences are inevitable.  

These are, more or less, the classic arguments and are extended by those who believe in the inevitable collapse or devaluation of fiat currencies, and that governments can’t be trusted with our savings. And these arguments are, at least, partially true. As we saw in Money Illusion, and as Buffet notes, real money is a wasting asset and isn’t something you should ever want to be heavily invested in for any length of time.

Sometimes these arguments are justified – when economies collapse anyone who can hoard away gold will generally find they’ve protected themselves – but usually they’re not. In particular, until or unless countries start accepting gold in lieu of taxes there’s going to be a need for fiat currencies.


However, goldbugs tend to take these arguments a step further, to take the view that people who disagree with them are part of a greater conspiracy. They gravitate to the backfire effect, and view every opinion contrary to theirs as evidence that they’re right. This isn't surprising, investing in gold is often more about fear than whether the asset class is over or undervalued. After all, if you believe things can only get worse it doesn’t matter what the price of gold is, you need more of it.

When people think about gold these are the arguments that get rehearsed. They’re the ones we can bring to mind – in the psychological parlance they’re “salient”, they make “obvious” sense to us. Salience is just a specialised form of the availability heuristic, which tells us that we’re biased by the fact that some information is easily retrievable from memory. Availability is implicated in all sorts of investing biases – regret, recency, anchoring, herding, hindsight and more.

The standard arguments for and against gold are highly salient; they revolve around whether or not we can trust governments with our investments, they’re all about fear and paranoia and sometimes, just often enough to make these arguments salient, this all comes true. However, the fear that we protect ourselves against using gold is often the wrong one: we don’t need gold to protect us against collapses in fiat currencies. We need gold to protect us against the collapse of countries.

Weimar and War

Occasionally some event occurs that is so salient that it scars not just the generation to whom it occurs, but those that come after.  Even today central bankers are still shying away from the mistakes made in the wake of the Wall Street Crash: the Chairman of the Fed probably owes his position to his knowledge of its causes and effects as this speech demonstrates. Similarly, people who see hyperinflation just around the corner are driven by perceived similarities with the German inter-war experience.

When the hyperinflation of the Weimar Republic took hold (see: Stuck In A Weimar World) gold held its value while the currencies of Germany and Austria imploded. As extreme fear took hold, the price of gold soared: in fact it completely decoupled from the rest of the economy.  This can be seen by looking at the ratio between gold and silver prices, which historically had hovered between 15 and 20.  In 1923 that relationship broke down, and the ratio climbed to over 160 (today it's somewhere in the mid-50's).

This was during a time of virtual civil war in Germany, while impossible First World War reparations were still being demanded by the victorious Allies and France had occupied part of the country in order to force payments.  The German nobility had been destroyed, the Kaiser dethroned, Lenin's communists were in charge in Russia and their compatriots in Germany had attempted a coup.  The world the German people knew was coming to an end.  If you stretch your imagination to breaking point can you see the similarities between then and now?

No, me neither.  Of course, we know all this anyway, thus proving that trying to find an anchor in the middle of a bubble is always difficult. At what point does gold, or any other asset, become overvalued in the absence of a breakdown in civil society? How do we avoid the problems that come when the herd decides to chase something up to a high that’s unrelated to its intrinsic value?

Changing Frames

The answer’s simple to state, but hard to achieve. We need to take a step back and establish some way of valuing the asset relative to the rest of the world. Valuing gold in terms of its own intrinsic worth is an exercise in self-fulfilling pointlessness: we know it’s a store of value that’s held it’s own against fiat currency over hundreds, if not thousands, of years. We know they’re not making it any more (although they are digging up more each year).  We know there are mad apocalyptic doomsayers burying it in bunkers to use for exchange  with sentient cockroaches in the event of global economic armageddon.  None of this is new information.

In order to figure out whether any particular asset is overvalued or not we need to change our frame of reference; we need to re-frame the argument. Instead of analysing gold or internet stocks or oil or tulip bulbs in terms of their own worth and scarcity we need to take a step back and look at them in relation to the alternatives that the rest of the world offers.

Finding these self-sufficient mechanisms for valuing assets of all kinds, unaffected by salience and existing frames, seems to be one of the key and central skills that Warren Buffett has brought to the task of investment. Somehow he’s able to clear his mind of all of the information that biases the way the rest of us look at stocks and other assets and develop his own, independent, valuation metrics. He then applies these ruthlessly to determine whether or not to invest.

Reframing the World

Classically many great thinkers have had to reframe existing ideas to make them accessible to other people.  Consider special relativity: a person riding on a beam of light from a clock face will experience time passing differently depending on whether they look at the image of the clock face travelling with them, where the time won't ever change, or their own watch, where time is passing normally. Time is relative to your frame of reference, not absolute: of course that's really re-framing an idea.

Done intelligently, these exercises serve to expand our thinking and to develop insights into the way we should approach difficult topics.  Such is Buffett’s analysis of the current valuation of the world’s gold:
“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money”
Whether you agree with the analysis or not this is a brilliant piece of psychological re-evaluation. Buffett reframes our perspective on how to value gold against other assets, he makes this alternative valuation metric salient in relation to the standard ways of doing so and does so by logically developing a valuation model based on simple, easy to understand logic so that it's available to our minds.

Salient No More

Even if you disagree you really ought to admire the skill with which he changes our perspective on the topic. It’s a masterclass in how to find an anchor in a bubble, and it offers us an insight into how he’s made his money over the years. He hasn’t done this by cleaving to other peoples’ ideas but through rational and clear-sighted analysis of valuations based on models he’s constructed for himself.  Sometimes these are wrong, but usually they're at least better than anyone else's.

The lesson, of course, is not to copy what Buffett does, but what he thinks. Don’t rely on others to decide what’s important but do your own thinking to determine this for yourself. You can’t change the way you think, but you can change what you think: we have to decide for ourselves what’s important and then act on it – and then, but only then, salience is golden.

Related articles:  
Salience added to the Big List of Behavioral Biases.


  1. you could have made your point in a lot fewer words. i gain more "value" from many tweets (those are my comments)

  2. Excellent article. That's exactly what he did. He re-framed it for us. Insightful journalism.

  3. What bullshit! In the example cited, gold is measured against U.S. DOLLARS, no matter what "assets" he uses as comparison. Those "assets" can only be valued against a common element, in this case, the dollar.

  4. Bull Indeed. Buffet's gold "framing" shows only that he is far outside his area of competence. It is a "brilliant" example of invalid re-framing and ownership bias. He compares apples to oranges and concludes (his) apples taste better. The value of gold is as an alternative to cash. Showing the small size of a pile of gold, or the huge size of dollar bills, that it currently takes to buy his companies tells nothing about the current value of gold. The current price of gold incorporates a value attributed to its superior longevity and its inability to be printed (exponentially) by governments. The premium that should be attached to those attributes is certainly arguable, and how the premium will change in the future is dependent upon governmental and economic performance. However, financial repression (read Carmen Rheinhart) will assure that cash will lose value over the next several years, with a reverse effect on gold. When in doubt, avoid the sure loser. Frame that.

  5. Well, the ownership bias argument generally works both ways, and at least we know where Buffett stands on that. I don’t think that “Invalid re-framing” is possible, by the way; framing itself is a value neutral term. The arguments being expressed by the frame may be more or less valid, according to taste.

    As for financial repression, we’re an equal opportunity website: see How Sneaky Governments Steal Your Money

    For a counterargument to that counterargument this version of the original paper has a couple of alternative analyses appended to it …

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