Many people think that gold should be part of any investment portfolio and the justification they give is usually twofold the first is that when equity markets crash gold tends to rally and it reduces your overall loss the second justification is to do with inflation when the price of goods and services goes up then gold tends to hold its value but is this borne out by historical data and what are the historical drivers of gold’s price let’s look at that in a bit more detail.
This is the price of gold since the 1930s in dollars per troy ounce if you look at the first half of the graph you can see that it’s kind of blocky and constant for long periods of time that’s because of the gold standard until 1933, these gold certificates could be used as currency in the U.S.
If you had one of these certificates you could cash it in for physical gold and the price of the US dollar was also linked to the price of gold this ended in 1971 when President Nixon announced that he was suspending the convertibility of the dollar into gold and suddenly the price of gold could vary according to market forces and the result was an extremely strong rally in gold or conversely a weakening of the dollar.
One of the benefits of holding any asset is the income that it generates so for example if you hold Marks & Spencer shares, you’re paid a dividend, so if you buy a hundred pounds of the stock, you’ll be paid six pounds a year dividend. Corporate bonds also generate an income but one of the big problems with holding gold is that it doesn’t generate an income, in fact, it will cost you to hold it.
In financial terminology, this is called a negative carry cost. The reason why having an income is useful is that it allows us to calculate the fair value of any asset.
The fair value of shares, property, vehicles and even intangible assets can be easily calculated because they have cash flows attached to them. A share generates a certain income in the form of dividends and this can be used to calculate its fair value.
Gold, however, does not generate any income, so the problem with gold is that we pay to buy gold on day one but instead of a dividend we have a storage cost and that carries on forever now that means that we can’t work out the fair value of gold, so we’ll never know if it’s expensive or if it’s cheap. The price of gold is simply what people are willing to pay for the shiny metal.
Now let’s see how gold has performed historically here’s a comparison with the S&P; 500 since January the first 1972 the average annual return of gold has been 7.3 % amounts exactly what you’d have got if you bought the S&P; 500 but of course one of the benefits of the S&P; 500 is that it generates dividends and if we reinvest those dividends over time the total return of the S&P; 500 gets boosted up to 10.5% per year which means that it’s massively outperformed gold over this period so you can see the power of having an income from any asset.
Now let’s look at what historically has driven the price of gold. One of the things about gold is that it’s very dense so when the earth formed a lot of the gold sank to the Earth’s core and that means there’s not much left in the crust which is where we live.
In other words gold is scarce and that pushes up its price. In fact, if all the gold ever mined was to be melted down into one big cube it would be about 21 meters on each side.
That’s enough to fill 35 double-decker buses or enough to fill about 1/10 of the Royal Albert Hall. The thing to remember is that gold is a currency, if you look on Bloomberg you’ll see it quoted using the symbol AU because the Latin name for gold is Aurum so when the price of gold goes up you could see that as a weakening of the dollar rather than just the strengthening of the price of gold.
Through this, we can drive a relationship that states that the demand for gold is inversely proportional with the demand for dollars. Thus when the demand for gold rises, its price rises and the demand for dollar decreases making it cheaper.
This means that in times of hyperinflation of the financial crisis, gold tends to provide the required stability and protection from loss, as we saw in 2008 when the dollar lost its value rapidly, gold rose in value.
The investment and savings of people quickly vanished but those who had their investments in gold were protected from it. Fear of hyperinflation is one reason why many retirees are rolling over their 401ks into gold IRAs.
Apart from the protection provided by gold, there seems to be no major factor to entice investors to invest more in gold because it lacks one key thing, which we have already discussed and that is periodic returns.
If you invest in gold, your savings will be locked in, they may appreciate in value but you will not be able to benefit from the appreciation unless you sell your gold. Holding on to gold will not bring you any receipt. Whereas other investments bring in periodic returns.
Another factor to look at is the interest rate. Last year saw 3-4 policy rate increases and this means that whenever the rates increase, deposits become more attractive and people buy government bonds and other instruments because of higher return, this higher return results in reduced demand for gold.
Thus when policy rates rise, the demand and thus the price of gold reduces. So if you invest in gold, to ride the rough tides during a crisis, you may, in fact, you will definitely be able to save your investment but if the policy rates rise, the capital appreciation can turn into depreciation and you may miss out on high returns. Thus the opportunity cost for stability is high return when policy rates go up.
So, is gold good for investment? It really depends on the needs of the investor. If the investor wants to achieve stability or reduce the risk profile of their portfolio then yes, gold should definitely be a part of any investment portfolio because it brings with it that element of stability but it lacks profitability and this is why investors looking for a high rate of return typically tend to keep gold to a minimum in their portfolio.