Gold has been around for thousands of years dating back to the earliest civilizations. Specifically, in circa 2600 BC the goldsmiths of ancient Mesopotamia (modern-day Iraq) crafted the earliest pieces of gold jewelry. In 564 BC, the first international gold currency was created by King Croesus of Lydia. Skipping forward over a thousand years brings us to the California Gold Rush in 1848 and South African Gold Rush in 1885, where people literally traveled halfway around the world to get their hands on the precious metal. Between the years of 1870 and 1900, all major countries other than China adopted the gold standard, thereby linking the value of their currencies to gold. Later on, in 1971, under President Nixon, the gold window was closed, in effect suspending the U.S. dollar convertibility to gold, resulting in the present day system of floating exchange rates.
Supply and Demand
Gold has been used for jewelry and decorative purposes for thousands of years, as well as an investment product (e.g. ,coins, bars, medals, ETFs, etc.). However, it is also increasingly used for industrial purposes, such as in electronic and medical components, due to its conductivity and extreme durability. During the period of 2005 to 2009, 61% of the world’s gold demand came from jewelry, with 27% and 12% coming from investment and industrial markets, respectively.
Unlike other commodities, gold is not consumed. Therefore, practically all of the gold ever mined still exists in accessible form. Between the same periods of 2005 to 2009, the majority of the supply came from mines (61%), followed by existing gold coming back into the market (29%), and finally central banks (10%). Gold reenters the market through jewelry (or coins, bullion, etc.) sales (remember those “cash for gold” commercials?) and central banks selling their reserves.
The most common types of gold investment are in physical gold (through coins, bars, or jewelry), exchange-traded funds (ETFs), and the stocks of gold mining companies. Each of these vehicles has its own characteristics:
Physical gold can be bought and sold through numerous outlets and can be stored in bank deposit boxes or even in your home. It is probably the most flexible type of gold investment simply because once it’s in your hand, it is yours to control.
Gold exchange-traded funds (ETFs) are a popular way to have gold exposure in your portfolio without the hassle of storing the physical metal. The three most popular gold ETFs are SPDR Gold Shares (GLD), iShares Comex Gold Trust (IAU), and ETFS Gold Trust (SGOL). Shares in these ETFs represent fractional interests in the assets of the fund, minus fees for management and storage. An ETF also allows the investor the opportunity to short the precious metal if he/she feels the price of gold will fall.
Mining stocks are an indirect way of investing in the yellow metal. As the price of gold rises, the profits of gold mining companies are expected to rise and, as a result, lift the price of its shares. But this is not always the case. As in any equity, there are numerous factors involved in valuing the security. These can include the maturity and geographic spread of mining projects, gold reserves, ore grades, costs, margins, profitability, strength of the balance sheet, the debt profile, and the quality of management. The gold mining stocks in the Value Line Investment Survey include Agnico-Eagle Mines (AEM), Anglogold Ashanti Ltd. (AU), Barrick Gold (ABX), Goldcorp Inc. (GG), Kinross Gold Corp. (KGC), and Newmont Mining (NEM).
The basic reason to put money into gold is to maintain its value. Most other assets require careful management to bloom, or will deteriorate with neglect or subpar oversight. Farmland must be tilled, hogs and cattle fed, fine art maintained and corporations managed. Gold is unique because it carries no credit risk. It is not a liability of anyone. It is not in danger of going bankrupt. Unlike currencies, the value of gold cannot be affected by a nation’s economic policies or undermined by inflation. For the yellow metal, an ounce is an ounce is an ounce, and it has been that way for all of time. Meanwhile, liquidity is very high for the metal, so an individual can easily exchange the asset if need be.
Gold has historically acted as an inflation hedge. Although it is a “form” of currency, gold’s value cannot be de-based by governments or central banks. Its value is purely determined by supply and demand. Moreover, commodities are often the root cause of inflation and since mining gold is a resource intensive business, the rise in commodity prices puts direct pressure on the cost of extracting gold, resulting in cost-push inflation. (Cost-push inflation occurs when rising input costs leads to persistently rising general price levels).
Additionally, the precious metal plays an important role in modern portfolio theory (MPT). Essentially, MPT states that a well built portfolio should include assets that have low correlations with each other. Meaning, you don’t want everything moving in the same direction all at the same time. And, historically, gold has had a very low correlation with other asset classes, making it a valuable piece of one’s portfolio.
Gold pundits argue that the main reason to avoid gold as an investment is because it has value only because we believe it has value. It is true that gold does have industrial purposes, but demand is relatively low in that area. The main factor driving the price of gold is whether or not the person sitting next to you is willing to pay more for it.
Celebrated investor Warren Buffett probably put it best in his 2011 Berkshire Hathaway (BRKB) Letter to Shareholders. To paraphrase, if you collect all of the gold in the world, which is about 170,000 metric tons, it would be worth roughly $9.6 trillion (based on the price per ounce in dollars as he penned the letter). Now, instead of collecting the gold, imagine you had $9.6 trillion in cash lying around. With that sum you could purchase all of the U.S. cropland (with an annual output of roughly $200 billion), plus 16 Exxon Mobils (XOM - Free Exxon Mobil Stock Report), the world’s most profitable company, and still have about $1 trillion left. Fast forward 100 years, and what do you have? He muses that the gold will be unchanged and still incapable of producing anything. However, in the second scenario, the farmland will have produced an abundance of crops (and will continue to do so), while the 16 Exxon Mobils will probably have delivered trillions of dollars of dividends to its investors, with trillions more in assets. To Mr. Buffet, it appears the choice is easy; gold is a poor investment.
At the end of the day, the choice of investing in gold may boil down to whether or not you are looking for a return of your money or a return on your money. If you think the economy is going “down the tubes,” then gold might be a reassuring investment. However, if you believe the economy is set to prosper, then other investments would likely provide better opportunities to augment your wealth.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.