Gold as an investment

Categories: Gold

This article discusses the use of the precious metal gold as an investment.

History

For the physical properties and history of gold, please see gold.

Gold as a store of value

For over two thousand years gold has been regarded as a form of money and as a store of value. The use of gold superceded alternatives for a number of reasons including its rarity, ubiquity, beauty, obvious & unique character (weight, softness), malleability and resistance to tarnish.

Since the collapse of the Gold Standard, gold has largely lost its role as a form of currency, but is still considered by many, especially by Central banks, as a store of value, to be used only as a last resort. Others see gold as nothing more than an investment to be traded along with other commodities such as copper or lead, as well as all other forms of investment such as property, bonds, stock market, hedge funds, private equity, and deposits.

However, gold does maintain a special position in the market with many tax regimes allowing gold to be traded as a VAT-free investment. Silver, and other precious metals and commodities rarely have the same allowance.

Gold as an investment

Modern day investors in gold may invest in gold for several reasons:

Speculation

The investor believes that he will make a profit from a rapid change in price. He may believe some future forseen or unforseen event will affect the demand for gold. He may think he has detected a pattern in the recent price behaviour which tells him the direction of the future price.

Insurance

The investor believes that certain events, if they occur, (e.g. war or crisis), may have a negative influence on the value of his other investments, but the opposite effect on the value of his gold.

Asset Allocation

Traditional asset allocation strategists used to recommend a 5% to 10% exposure to gold was sensible on the grounds of diversification. Although the inclusion of gold in portfolios has largely been abandoned since the 1980s, it is once again being considered by asset allocators.

Portfolio Hedging

Similar to asset allocation strategies, except the purpose of the investment is to hedge against unforseen calamities which may affect the price of other investments negatively. Portfolios which contain gold are better able to withstand market surprises than those which don't. Recent independant studies have found that traditional diversifiers, such as bonds, property and and hedge funds often fail to stand up to market stress and may sell off with equities in times of uncertainty. Even a small allocation of gold to a portfolio significantly improves its performance during unstable periods.

Gold Bulls

Gold bulls, in the traditional sense, believe, fear, or even hope for Armageddon or the total collapse of the monetary system, and they hope that by holding gold they will survive and become rich.

Inflation hedgers

For centuries gold has remained a store of value. It has performed this function best in times of high inflation. Investors thus buy gold to protect themselves against a rise in inflation and a decline in the value of money, particularly paper money, or fiat money.

Currency Speculators

Since gold is priced in US Dollars, speculators who believe the dollar will decline, may buy gold. They think that if the Dollar declines, the gold price will remain constant in other currencies, thus rising in US Dollar terms. Gold may also be bought if they feel that a different currency will decline, since they expect the dollar price to be stable, but the foreign currency price to rise.

Hoarders

Some investors respect gold as a long term store of value, and seek no profit, other than to maintain their buying power. By buying gold and hanging on for the long term, they believe they can keep their wealth intact.

Cacheurs

Physical gold is anonymous. Its ownership is not written down or recorded anywhere. It is as anonymous as a banknote, but without the depreciation. Cacheurs seek to hide part of their wealth from their wives, family, tax authorities, creditors, extortionists, kidnappers, blackmailers, police, invaders or others. The anonymous nature of gold allows them to store a large value in a very small space, without fear of depreciation or erosion over a long period of time. A tonne of gold would be equivalent to a cube of side 37.27cm (1 ft 2²⁄₃ in), or roughly the size of a basketball. This small cube would contain 32,150 troy ounces, and be worth about $15 million.

Gold Price

The following table sets out how gold has performed compared to a few other investments:

Factors influencing the gold price

Historically, before 1970, the price of gold was set by the US Government, so that an ounce of gold represented a certain fixed number of dollars. Until that time other countries set their currencies as being convertible into dollars at a fixed exchange rate, and thus the price of gold in those foreign currencies was also constant, until they devalued against the dollar. The dollar was itself occasionally devalued against gold by government edict. That was known as the gold standard. Since 1970, the price of gold has been allowed to float freely.

The usual benchmark for the price of gold is known as the London Fixing. This is done at a twice-daily meeting of a committee consisting of five representatives from bullion-trading firms. The meeting was chaired from its inception in 1919 until 2004 by the representative from N M Rothschild & Sons. In May of that year, Rothschild announced its intention to withdraw from the commitee, and was replaced by Barclays Bank, and the chairmanship is now rotated annually. The other four representatives are the successor firms who have acquired the original London bullion dealers in the intervening years.

In addition to the gold fix, there is active gold trading based on intra-day spot price. These are derived from multiple gold-trading markets around the world as they open and close throughout the day.

Today, like all investments, and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and dis-hoarding. Unlike most other commodities, the hoarding and dis-hoarding plays a much bigger role in affecting the price, since almost all the gold ever mined still exists and is potentially able to come on to the market at the right price. If, for example, the gold price were $100,000 an ounce, queues would form outside bullion dealers as people tried to sell their wedding rings. Most of the gold ever produced sits in ingots at various Central Banks, to be used only in a last resort in case of a national crisis. Given the huge quantity of above ground hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production or gold jewellery demand.

Sentiment

It used to be said that "Gold is the world's frightened bunny". Whenever crisis threatened, the demand for physical gold increased.

Bank failures

When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around the paper dollars issued by their bank rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, they would queue up to change their paper money back into gold. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the holding of gold by American citizens.

Inflation

Most paper currencies which ever existed have been inflated out of existence. Even the very few which have survived a hundred years or more, have seen almost all of their value eroded by the printing of paper money, or the inflation of the money supply. Rising prices, known as inflation are a symptom of the inflation of the money supply. In times when inflation is high, or is expected to be high, because it is rising, people seek protection through holding real assets rather than fiat money, which can be printed ad infinitum. History is littered with examples of currencies which have collapsed in hyperinflation. Gold, which is a real asset, can never be printed by any government, nor is it a claim against any creditor. The demand for gold rises in inflationary times, pushing up the gold price.

War, invasion, looting

In times of national crisis, people fear that their assets may be seized, and the currency may become worthless. They see gold as a solid asset which will always buy bread or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.

Production

According to the World Gold Council, annual gold production over the last few years has been close to 2,500 tonnes. However, the effects of official gold sales (500 tonnes), scrap sales (850 tonnes), and producer hedging activities take the annual gold supply to around 3,500 tonnes.

Demand

About 3,000 tonnes goes in jewellery or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds. For the last few years, the official sector sales of around 500 tonnes have been taken up by retail investors and gold funds.

Supply and Demand

Some investors consider that supply and demand factors are less relevant than with other commodities since most of the gold ever mined is still above ground and available for sale at a price. However, supply and demand does play a role. According to the World Gold Council (www.gold.org), gold demand rose 29% in the first half of 2005. The increase came mainly from ETFs (Gold Funds), but also from jewellery. Gold demand was at an all time record. Demand from the electronics industry is rising by 11% a year, jewellery by 19%, and industrial and dental by 21%.

Investment Strategies

Technical Analysis

Many investors base their investment decisions on various types of technical analysis. Typically this involves looking at past price patterns, and trying to draw a conclusion as to the future price trend. This might include any of the following strategies:

Buy low, sell high

The investor believes the price will revert to a previous level, thus he will buy after a fall and sell after a rise. The assumption is thus that the present price is wrong, and the previous price must have been the right one.

Buy on breakout

The investor looks for a previous price peak or summit, from which the gold price subsequently declined. This price, is known as a resistance point, and the assumption is that it represents a price at which more sellers than buyers appear. The more times the gold price reaches the resistance level, and the more time it spends there, the stronger the resistance is thought to be. When finally the price breaks-out to a higher level than the resistance point, it is assumed that there are no sellers left, and that the price can only rise. The previous resistance level is assumed to become a support level, below which the gold price will not fall.

Momentum trading

The assumption is that the price trend is likely to continue in the same direction as the recent days, weeks, months, or years. However in order to determine how likely it is that the trend will contine, the investor will employ a variety of techniques to determine the strength of the existing trend. For example, the investor may build a relative strength indicator by multiplying recent price changes by volume, and possibly giving more weight to recent price changes than older ones. Moving averages may be constructed, which would have given accurate buy and sell signals in the past (e.g. "buy when the 45 day moving average turns up, sell when it turns down"). Multiple moving averages may be used (e.g. "buy when the 20 day moving average moves above the 50 day moving average")

Charting

There are many other price patterns that are believed to represent buy or sell patterns, usually because a similar pattern was seen before. The criticism is that charts are open to varying interpretations, and it is often only possible to see the pattern after the price move has occurred.

Methods of investing in gold

Investment in gold can be done directly through ownership, or indirectly through certificates, shares, futures etc. However, gold's benefit as a secure store of wealth is only realised when it is directly owned. Direct ownership of gold is often called 'allocated gold', whereas a gold-account is usually 'unallocated', simply being a promise to deliver gold when needed - there is likely little real gold there to back it up day-to-day. In the event of an unallocated gold-account provider going bankrupt, little would be returned to the investor, whereas allocated gold would have to be returned in full as the customer's property.

Bullion

The most traditional way of investing in gold is by buying bullion bars. In some countries, like Switzerland and Liechtenstein, these can easily be bought or sold over the counter of the major banks. Bars are available in various sizes. In Europe these would typically be the 12.5kg bar, and the 1kg bar. (1kg=32.15072 Troy ounces), although many other weights exist, such as the Tael, the 10oz and the 1oz bar.

Coins

Buying bullion coins is a popular way of holding gold. Typically bullion coins are priced only, or mainly according to their weight, with little or no premium above the gold price. Amongst the most popular bullion gold coins are the South African Krugerrand, the Canadian Maple Leaf, and the Australian Nugget. All these coins are popular because they contain exactly one troy ounce of gold. Other popular one ounce bullion coins include the American Gold Eagle, the Chinese Panda, and the Austrian Philharmonic. Other coins which are used as bullion coins include the British Sovreign, and the Swiss Vreneli, but these are much lighter than one ounce, making it difficult for an inexperienced person to know their value. Again the large Swiss and Liechtenstein banks will buy and sell these coins over the counter. Many other bullion coin and bar dealers can be found around the world by a simple internet search.

Gold Certificates

A certificate of ownership that gold investors hold instead of storing the actual gold bullion. Gold certificates allow investors to buy and sell the security without the hassles associated with the transfer of actual physical gold. As a certificate, it is just a piece of paper, and thus a claim on another person's gold. Some would argue that it is not the same as owning the real thing, especially in a war, crisis, or credit collapse.

Gold Accounts

All Swiss banks allow gold accounts where gold can be instantly bought or sold just like any foreign currency. Unlike physical gold, the customer does not own the actual metal, but rather has a claim against the bank for a certain quantity of metal. If the bank were to fail, the customer would be unable to claim the gold and would be a general creditor.

Gold Shares

These do not represent gold at all, but rather are shares in gold mining companies. If the gold price rises, the profits of the gold mining company could be expected to rise and as a result the share price may rise. However, there are many factors to take into account and it is not always the case that the share prices rise when gold rises. Some of the following questions should be asked before investing in the shares of a gold mining company: Has the company already sold its future gold production, through forward sales? Is the company already producing gold, or is it mainly exploring for gold? Does the company make a profit? How much many years of ore reserves are left in the mines before they have to be closed down? What PE ratio and dividend yield does the company have now and in the following years? Are the mines subject to political or economic risks?

Gold Bullion securities

These are traded on the major stock exchanges including London, New York and Sydney, under the symbol GBS or GBL. Each GBS was originally represented by exactly one-tenth of an ounce of gold. Due to costs, the amount of gold in each certificate is now slightly less. They are fully backed by gold which is both deposited and insured. The gold can be withdrawn, subject to a minimum size of 100,000 GBS. They represent a quick and easy way for an investor to gain exposure to the gold price, without the need to deal with the hassle of storage of physical bars. Typically a small commission of 0.2% is charged for trading in GBS and a small annual storage fee is charged. The annual expenses of the fund such as storare, insurance, and management fees are charged by selling a small amout of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time. In some countries, GBS represent a way to avoid the sales tax or the VAT which would apply to physical gold coins and bars. ETFs like GLD have emerged as a convenient investment vehicle.

Spread Betting

Firms such as Cantor Index and IG Index, both of the UK offer the ability to take a bet on the price of gold through what is known as a spread bet. Recently the price of December gold was quoted at $475.10 to $476.10 per troy ounce. An investor who thought the price would go down would "sell" at $475.10. The minimum bet is $2 per point, (i.e. equivalent to 200 ounces). If the price of gold finished at $480.10 when the seller closed his bet, the loss would be 500 points multiplied by the bet of $2 making a loss of $1000 in total. No commissions or taxes are levied in the UK on spread betting.

Futures contracts

Futures based on gold currently trade on various exchanges around the world. In the US this occurs primarily on COMEX (Commodity Exchange) which is a subsidiary of the New York Mercantile Exchange. Speculation about the future price of gold and other commodities is carried on at COMEX.

Gold's value versus money supply

Historically increases in the supply of paper money or fiat money supply would cause the demand for gold to increase. There was a time when gold was money and vice versa. If citizens felt that there may be insufficient gold to cover the paper money in circulation, they would queue up at the bank to change their paper currency back into gold.

However, since the Gold Standard was abolished in 1968, governments have been free to print as much money as they choose, without fear that their populations will come knocking on the Central Bank's door demanding to change their paper money back into gold.

In January 1959 US M3 money supply was $288.8 billion, and the Official Gold Holdings of the United States was then 17,335.1 tonnes, or 557,336,000 ounces (there are 32,150.7 troy ounces in a tonne). That means that in 1959, there were $518 in circulation for every ounce of gold reserves held by the USA. Although the theoretical price should then have been $518 per ounce, the actual price, as fixed under the gold standard was only $35 an ounce.

By August 2005, the US M3 money supply had risen to $9,873.9 billion, whilst at the same time the Official Gold Holdings of the United States had fallen to just 8,133.5 tonnes, or 261.50 million Troy Ounces. This means that today, in 2005, there are $37,831 in circulation for every troy ounce of gold held by the United States.

The above numbers show the falling influence of gold in the monetary system of the world today. Goldbugs believe, or even hope, that one day gold's importance will return as the printing of paper money gets out of control and we end in a hyper-inflationary fiat money collapse.

They sometimes cite the huge US Government Debt and budget deficits as additional evidence that things are getting out of control. For example, in 1959 US Government debt was $290,797,771,717.63 ($290 billion), whereas by October 2005 it had reached $7,978,989,702,813.02 ($7,978 billion). The US budget deficits are the largest in history and accourding to the U.S. Government's own published plans, the budget will not be balanced in the forseeable future.

Others argue that gold's role in the world's monetary system has ended, and that it will never again represent the store of value that it once was. John Maynard Keynes, the great economist, as early as 1924, described gold as a "barbarous relic". Many Central Banks, especially in Europe seem to agree, and have been selling off their gold reserves at the rate of around 500 tonnes a year. Given that the gold price peaked at around $850/oz t ($27,300,000 per tonne) in 1980, and is now well below that, gold has proven to be one of the worst investments you could have made 25 years ago. Possibly Keynes was right after all.

Sources for the above information:

• US Government debt: www.publicdebt.treas.gov
• Official gold reserves: www.gold.org
• US Money supply: www.federalreserve.gov
• US Budget (deficits): www.fms.treas.gov

Why use gold in a portfolio?

As a tangible investment gold is sometimes held as part of a portfolio because over the long term gold has an extensive history of maintaining its value. It has in the last century gained ground in relation to fiat currencies owing to inflation. Gold becomes particularly desirable in times of extremely weak confidence and during hyperinflation because gold maintains its value even as fiat money becomes worthless. People who enjoy investing in gold are known as goldbugs.

Prices data sources

• Farm labour wage rate table
• Money Supply Table
• US Government Debt Table

External links

• LBMA - London Bullion Market Association
• Buying gold FAQs and prices
• Gold market in depth