Investing In Gold: Excavating Investors’ Most Popular Precious Metal

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Investing In Gold: Excavating Investors’ Most Popular Precious Metal

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Humans have been using gold as both a medium of exchange and a store of wealth for thousands of years. That’s not surprising given the shiny yellow metal properties: it’s virtually indestructible, impervious to corrosion or decay; it’s readily melted into portable forms such as coins, jewelry, and bars; and its supply is limited – which means that, unlike government-issued money, gold’s worth can’t be diluted by inflation or fresh currency creation.

While other forms of cash – including paper money – eventually proved more useful as day-to-day currency, their value was directly linked to a state’s physical gold reserves under a system which persisted until relatively recently. Only in the 1970s was this international “gold standard” completely abandoned and gold’s price allowed to float freely. It’s been viewed as an investment ever since, with its unique properties serving to make the metal an asset class in its own right. And a successful one at that: the chart below shows gold’s price performance since the end of the gold standard.

The price of gold
Source: Macrotrends.net

What drives the price of gold?

Before discussing why, whether, and how to go for gold, it’s important to take a step back and understand what drives price changes in the first place. From a broad macroeconomic perspective, there are three key factors: the “real” yield on government bonds, US dollar strength, and overall investor sentiment.

Let’s start with real yield. This is quite simply the return available to investors in government bonds (also called the “nominal” yield) minus the rate of inflation. As shown below, the gold price has an inverse relationship to real yield; when the real yield falls, gold tends to rise.

Gold's price versus real yields
Source: JPMorgan Chase

This relationship makes sense once you take a closer look at the two things that determine real yield: government bond yields and inflation. If nominal yields rise, then the “opportunity cost” of owning gold instead of bonds increases; gold, after all, generates no income. Gold therefore looks less attractive when bonds offer better returns, causing its price to fall. But when inflation is rising, the opposite is true. Since government-issued currencies – as well as bonds’ future payouts – are worth less when goods and services grow more expensive, investors are drawn in such scenarios to gold’s stability, underpinned by its limited supply.

Gold and yield relationship formulas

The second key determinant of the price of gold is the value of the US dollar. Like most internationally traded commodities, gold’s price is quoted in dollars. If the dollar weakens compared to other currencies, gold becomes cheaper to buy overseas – increasing international demand and pushing up the metal’s price. A declining dollar has the added effect of encouraging American investors to seek out stores of value – another source of increased demand (and therefore prices) for gold.

While this inverse relationship generally holds true, it’s important to recognize that there can be periods where both the dollar and gold strengthen simultaneously. That’s because the US dollar, along with the Japanese yen and Swiss franc, is considered a “safe-haven” investment – one which holds up well in times of financial or economic crisis. Since the same is true of gold, global uncertainty can cause a “flight to safety” in which both it and the aforementioned currencies see prices rise in tandem.

The perception of gold as a safe-haven asset brings us to the third and final driver of its price: overall investor sentiment. During periods of economic and/or geopolitical volatility, such investments are understandably in demand. Also, gold’s status as a physical commodity that can’t be printed like money makes it particularly popular if people are losing faith in the banking system. This phenomenon also helps explain the birth and rise of cryptocurrencies such as bitcoin which operate independently of national authorities. Of course, such a source of demand is likely to fall when times aren’t so tough – and with it part of the support for gold prices.

Why invest in gold?

You’ll have already begun to appreciate why gold sits alongside the likes of stocks and bonds in many investors’ portfolios. First, investing in gold provides you with protection against rising inflation. Take the “All-Weather Portfolio” created by legendary money manager Ray Dalio, for example, is designed to perform well in all economic environments. It’s split across assets suited to different parts of the economic cycle, defined by rising/falling economic growth and rising/falling inflation. Gold’s inclusion is intended to help the portfolio do well during those economic environments where inflation is increasing.

Second, recall gold’s perceived safe-haven status. That means it can help compensate for losses elsewhere in your portfolio during times of economic and/or geopolitical turbulence. The chart below illustrates how gold’s price has performed during historical periods of significant stock market decline; in most instances, gold went up – and on the few occasions where it did decline, it did so by only a minimal amount.

Gold as a safe haven
Source: State Street Global Advisors

Some investors see gold as protection against not just short-term market upheavals but also the potential long-term unintended consequences of current government and central bank policies. Authorities’ cash-splashing attempts to battle the economic fallout of the coronavirus pandemic are being funded by unprecedented peacetime levels of bond issuance. Many of these bonds have been bought by countries’ own central banks as part of “quantitative easing” programs.

Essentially, central banks are printing money and lending it to governments. This is called “debt monetization”, and it’s a risky business – the risks in question being runaway inflation and loss of faith in the monetary system. Gold represents a bulwark against such potentialities, however unlikely their occurrence – which may be one reason why it’s proved so popular in 2020.

A final point worth mentioning is gold’s lack of correlation with other asset classes. Adding the metal to your portfolio can provide you with a source of return (via price appreciation rather than investment income, obviously) that’s unlikely to move closely in sync with stocks and bonds beyond the macroeconomic factors outlined above. Gold’s presence increases diversification, lowers volatility, and therefore leads to higher risk-adjusted returns. The chart below compares gold’s average annual return to those of other major investments over the past few decades. Over the past 30 years, this was an impressive 5.6% – and at the same time the gold price exhibited a 0.00 and 0.07 monthly correlation to the US stock and bond markets respectively.

Gold's return versus other assets

How to invest in gold

Got the gold bug? There are a few different ways to invest. Besides donning jewelry, you can buy physical gold coins or bars, purchase gold futures contracts, invest in gold exchange-traded funds (ETFs), or even pick up shares of gold miners. Let’s briefly examine the pros and cons of each.

Buying the physical metal arguably gives you the best correlation to the “spot” – that is, the current – price of gold. And physical gold is also the obvious choice for those prepping for an actual doomsday scenario of monetary and financial system collapse. The downside is that unless you’re happy to stash that bullion at home, you’ll have to pay annual fees for storage and insurance.

Futures contracts have the advantage of leverage. For just a small outlay you can gain exposure to the same levels of profit (or, crucially, loss) that you’d get from investing a large sum in gold itself. That’s also a drawback, however: the smallest futures contract is worth ten troy ounces, so a gold price at $2,000 per troy ounce means you’re looking at making a bet worth at least $20,000! Another disadvantage is that futures contracts have expiry dates, which means you’re constantly having to reinvest in newer contracts that are typically more expensive than the spot price of gold. All this rolling over adds up over time.

The biggest benefit of investing in gold ETFs is that, unlike futures contracts, they’re super easy to access: anyone with a brokerage account can buy in. While lacking futures’ leverage, ETFs replicate gold price performance by either holding physical bars or themselves investing in gold futures contracts. That means they face the same problems as those individual approaches, incurring either storage and insurance costs or the hassle of constantly reinvesting funds into newer, pricier contracts. Combined with (albeit small) management fees, the result is that ETF performance inevitably deviates somewhat from that of actual gold.

Lastly, you can invest in shares of gold-mining companies. The main advantage of this is regular income: ironically, unlike the metal they unearth, many miner stocks pay a decent dividend. The downside to miner stocks is that they’re volatile, with share prices tending to rise and fall faster than the price of gold itself. Individual companies may also be subject to a range of idiosyncratic issues including politics, environmental concerns and operational blockage. These can introduce unwanted risks to your portfolio.

Concluding – with a word of caution

We’ve talked a lot about the reasons for investing in gold – but don’t forget that these could all work in reverse. Gold may be a good hedge against inflation, but that means it could perform poorly in an environment where inflation is falling. Similarly, gold’s price tends to struggle in scenarios where nominal bond yields are rising, where the US dollar is strengthening, and where investors are becoming more comfortable with taking risks at the expense of stuffy old safe havens.

Gold, as discussed, can help protect your portfolio during times of market stress; it can help offset losses when stocks or bonds are falling. Unfortunately, however, this relationship doesn’t always hold up during massive selloffs. These often involve investors selling their most readily tradable assets – such as gold – in order to meet “margin calls” – demands from their broker that enough cash be raised to cover possible losses. As investors flog their gold to make ends meet, the metal’s price may also drop, at least temporarily – as seen during the March 2020 meltdown.

And with that final word of caution, we’ve reached the end of this Pack. You now have a good understanding of the principal factors driving the price of gold, the reasons investors are fond of the stuff, and how you can go about taking the Scrooge McDuck plunge yourself. Gold luck!

In this Pack, you’ve learned:

🔹 Gold was one of humanity’s first currencies. Since governments separated its value from that of modern money, gold has been viewed more as an investment.

🔹 The price of gold is mainly driven by government bond yields (higher yields = gold lower), inflation (higher inflation = gold higher), the US dollar (strong dollar = gold lower), and overall investor sentiment (more risk-averse = gold higher).

🔹 Investing in gold can provide an inflation hedge, protect a portfolio during times of economic and/or geopolitical turbulence, and supply an additional source of return that’s largely uncorrelated with other major asset classes.

🔹 You can back gold by buying physical gold coins or bars, purchasing gold futures contracts, investing in gold ETFs, or even by picking up gold miners’ shares.

🔹 But you should also be aware of the potential risks. As well as unfavorable macroeconomic conditions, gold may fail to provide portfolio protection during large market selloffs.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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