Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar and U.S. stocks, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. The price of gold reacts to supply and demand changes and can be influenced by consumer spending and overall levels of affluence.
Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold’s value does not arise from its usefulness in industrial or consumable applications. It arises from its use and worldwide acceptance as a store of value. Gold is money.
In contrast to other commodities, gold does not perish, tarnish or corrode. Gold mined thousands of years ago is no different from gold mined today. Therefore, gold existing in the aboveground gold stock is interchangeable with newly mined gold.
Why Should I Own Gold?
The primary reasons why investors own gold are:
- As a hedge against inflation
- As a hedge against a declining US dollar
- As a safe haven in times of geopolitical and financial market instability
- As a store of value
- For economic security
- For physical security
- For unexpected needs
- For insurance
- For confidence
- For income
- As a portfolio diversifier
- Hedge against inflation
Gold is renowned as a hedge against inflation. The most consistent factor determining the price of gold has been inflation – as inflation goes up, the price of gold goes up along with it. Since the end of World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979, and 1980. During those five years, the average real return on stocks, as measured by the Dow, was -12.33%; the average real return on gold was 130.4%. Today, a number of factors are conspiring to create the perfect inflationary storm: an extremely stimulative monetary policy, a major tax cut, a long term decline in the dollar, a spike in oil prices, a mammoth trade deficit, and America’s status as the world’s biggest debtor nation. According to Bloomberg the stimulus plan will pump $9.7 trillion into the economy, and many analysts believe that the monetary stimulus efforts will cause a spike in inflation, driving gold higher.
Hedge Against a Declining Dollar
Gold is bought and sold in U.S. dollars, so any decline in the value of the dollar causes the price of gold to rise. The U.S. dollar is the world’s reserve currency – the primary medium for international transactions, the currency in which the worth of commodities are calculated, and the currency primarily held as reserves by the world’s central banks. However, now that it has been stripped of its gold backing, the dollar is nothing more than a fancy piece of paper. The dollar has been in an overall downtrend since 2001-2002, and this longer-term down trending pattern seems well established and likely to continue. The Dollar Index which is a widely used index that measures the US dollar relative to a basket of foreign currencies has already dropped more than 30% since 2001 while gold has risen 300%.. (The currencies in the Index include the Euro, Yen, Sterling, Canadian Dollar, Swedish Kroner and Swiss Franc).
Gold as a Safe Haven
Despite the fact that the United States is the world’s only remaining superpower, there are a myriad of problems festering around the world, any one of which could erupt with little warning. Gold has often been called the “crisis commodity” because it tends to outperform other investments during periods of world tensions. The very same factors that cause other investments to suffer cause the price of gold to rise. A bad economy can sink poorly run banks. Bad banks can sink an entire economy. And, perhaps most importantly to the rest of the world, the integration of the global economy has made it possible for banking and economic failures to destabilize the world economy.
As banking crises occur, the public begins to distrust paper assets and turns to gold for a safe haven.
When all else fails, governments rescue themselves with the printing press, making their currency worth less and gold worth more. Gold has always risen the most when confidence in government is at its lowest.
Gold as a Dependable Store of Value
One major reason investors look to gold as an asset class is because it will always maintain an intrinsic value. Gold will not get lost in an accounting scandal or a market collapse. Economist Stephen Harmston of Bannock Consulting had this to say in a 1998 report for the World Gold Council, “although the gold price may fluctuate”, over the very long run gold has consistently reverted to its historic purchasing power parity against other commodities and intermediate products. Historically, gold has proved to be an effective preserver of wealth. It has also proved to be a safe haven in times of economic and social instability. In a period of a long bull run in equities, with low inflation and relative stability in foreign exchange markets, it is tempting for investors to expect continual high rates of return on investments. It sometimes takes a period of falling stock prices and market turmoil to focus the mind on the fact that it may be important to invest part of one’s portfolio in an asset that will, at least, hold its value”.
Today is the scenario that the World Gold Council report was referring to in 1998.
Gold is a unique asset in that it is no one else’s liability. Its status cannot therefore be undermined by inflation in a reserve currency country. Nor is there any risk of the liability being repudiated. Gold has maintained its value in terms of real purchasing power in the long run and is thus particularly suited to form part of central banks’ reserves. In contrast, paper currencies always lose value in the long run and often in the short term as well. In March 8th 2004 an announcement was made by the European Central Banks concerning the second Central Bank Gold Agreement. Like the first agreement this covered a five-year period, in this case from September 27th 2004 (immediately after the expiry of the first Agreement) to September 26th 2009. The second agreement started by reaffirming the first clause in the 1999 agreement: “Gold will remain an important element of global monetary reserves”.
Countries have in the past imposed exchange controls or, at the worst, total asset freezes. Reserves held in the form of foreign securities are vulnerable to such measures. Where appropriately located, gold is much less vulnerable. Reserves are for using when you need to. Total and incontrovertible liquidity is therefore essential. Gold provides this.
Be Ready for Unexpected Needs
If there is one thing of which we can be certain, it is that today’s status quo will not last for ever. Economic developments both at home and in the rest of the world can upset countries’ plans, while global shocks can affect the whole international monetary system. Owning gold is thus an option against an unknown future. It provides a form of insurance against some improbable but, if it occurs, highly damaging event. Such events might include war, an unexpected surge in inflation, a crisis leading to repudiation of foreign debts by major sovereign borrowers, a regression to a world of currency or trading blocs or the international isolation of a country. In emergencies countries may need liquid resources. Gold is liquid and is universally acceptable as a means of payment. It can also serve as collateral for borrowing.
Gold – Ultimate Confidence
The public takes confidence from knowing that its Government holds gold – an indestructible asset and one not prone to the inflationary worries overhanging paper money. Some countries give explicit recognition to its support for the domestic currency. And rating agencies will take comfort from the presence of gold in a country’s reserves. The IMF’s Executive Board, representing the world’s governments, has recognised that the Fund’s own holdings of gold give a “fundamental strength” to its balance sheet. The same applies to gold held on the balance sheet of a central bank.
Gold as an Income Generating Asset
Gold is sometimes described as a non income-earning asset. This is untrue. There is a gold lending market and gold can also be traded to generate profits. There may be an “opportunity cost” of holding gold but, in a world of low interest rates, this is less than is often thought. The other advantages of gold may well offset any such costs.
Gold as a Portfolio Diversifier
The most effective way to diversify your portfolio and protect the wealth created in the stock and financial markets is to invest in assets that are negatively correlated with those markets. Gold is the ideal diversifier for a stock portfolio, simply because it is among the most negatively correlated assets to stocks. Obviously the price of gold can fluctuate, but so can the exchange and interest rates of currencies held in reserves. Gold has good diversification properties in a currency portfolio. These stem from the fact that its value is determined by supply and demand in the world gold markets, whereas currencies and government securities depend on government promises and the variations in central banks’ monetary policies. The price of gold therefore behaves in a completely different way from the prices of currencies or the exchange rates between currencies. Investment advisors recognize that diversification of investments can improve overall portfolio performance. The key to diversification is finding investments that are not closely correlated to one another. Because most stocks are relatively closely correlated and most bonds are relatively closely correlated with each other and with stocks, many investors combine tangible assets such as gold with their stock and bond portfolios in order to reduce risk. Gold and other tangible assets have historically had a very low correlation to stocks and bonds.
Although the price of gold can be volatile in the short-term, gold has maintained its value over the long-term, serving as a hedge against the erosion of the purchasing power of paper money. Gold is an important part of a diversified investment portfolio because its price increases in response to events that erode the value of traditional paper investments like stocks and bonds.