The precious metals market is generally considered to be gold, silver and platinum. Silver and platinum also have widespread industrial use, leaving gold as the purest definition of a precious metal.
The yellow metal is loved by some and hated by others. The middle ground has been hard to find. It has been around since the beginning of time and simply refuses to disappear, despite the best efforts of some governments and central banks to make it obsolete.
Gold is misunderstood. Its detractors see it as a lump of metal that doesn’t have many uses and will sit in a safety deposit box, paying no dividends or interest. What can possibly make it attractive?
For one thing, gold should be treated as a currency rather than an investment.
Like gold, a dollar doesn’t pay any interest unless it is loaned out. Our financial system has made it easy to loan dollars; the borrowers pay rent on the dollars in the form of interest. Gold loans are less common.
A more fair comparison would be if an investor put a $100 bill in his safety deposit box along with a gold coin, both would earn the same rate of interest - zero.
Gold has one feature that makes it appealing over paper currency; it cannot be diluted or produced out of thin air.
Theoretically, the amount of money created by a country in a given year should be equivalent to the amount of goods and services it has produced.
Yet by the end of 2012 many governments and their central banks had been printing money at an unprecedented rate without the corresponding level of economic activity. Without getting technical, the currency of these countries is diluted when unwarranted printing of money occurs.
Some refer to such activities as legalized counterfeiting. It is easy to “turn on the printing presses” and create more money without any justification for doing so. On the other hand, it is impossible to exponentially increase the amount of gold in the world. As a currency, it has held its purchasing power over the long term much better than paper dollars.
Gold, like every other asset class, has periods of time when it is in favour and periods of time when it is out of favour. Those who dismiss gold in an offhand manner may not have taken the time to understand its role in the world’s monetary system.
Those who like gold regardless of the circumstances are often labeled ‘gold bugs’. Unfortunately, those who recognize that gold comes into favour from time to time and then falls out of favour as circumstances change are also labelled gold bugs or speculators when they recommend gold.
There are points in time when it makes sense to own gold in a portfolio and other times when it does not make sense. Those who fail to recognize that and dismiss gold as a ‘barbaric relic’ may not have taken the time to understand the role it plays. If it hasn’t disappeared as a financial asset in the past 10,000 years it is unlikely it will disappear in the near future.
The reason that gold is an important asset class is that it adds an element to a portfolio that no other investment provides.
Few investors or governments want gold to succeed because it often means everything else is a mess. But it also means that gold acts unlike anything else in a portfolio, making it the ideal complement to the other asset classes. However, there still seems to be no moderate position with regard to this asset.
Gold bugs can point to those cataclysmic periods in time where gold was the only investment that held its value. There have been periods of currency devaluation in Argentina, Germany and even the United States where gold was one of the few asset classes that held its value as the currencies became almost worthless.
With hyperinflation rampant, one ounce of gold reached a value equal to several trillion German marks in 1923.
Detractors will similarly select periods where gold has performed poorly to make their case. In January 1980 the price of gold peaked around $850 per ounce before declining to just over $250 in September of 1999.
The truth lies somewhere between these two extremes. There will be times when an investment in gold will deliver great returns and times when it will fall in value. Of course, that is true with almost all investments.
Trying to determine when that might happen is always difficult but gold presents special challenges.
Gold’s Unique Role
Gold doesn’t do anything. It has no earnings and no debt; it generates no profits and no losses. Gold has no employees, few industrial uses and doesn’t rust. It is just a relatively rare and indestructible lump of metal.
But all of those shortcomings also make it very attractive. Its rarity means that a sudden supply won’t be dumped onto the market to disrupt the supply/demand ratio. Its limited industrial use ensures a large amount of gold will not disappear into the manufacturing process and once again upset the supply/demand ratio. Its indestructibility means no special care must be taken to ensure its long term viability. Gold cannot be created from thin air, counterfeited or diluted. It remains constant.
Another feature of gold that makes it attractive as a currency is the fact that it is easily divisible without losing any value (it is fungible). In the barter system, it is difficult to trade a half a cow.
Using other ‘rare’ commodities such as diamonds also has its drawbacks. Value is lost if a large diamond is split into smaller diamonds.
If all of these characteristics make gold sound like a foolproof currency, then you would be right. It can’t be tampered with and therefore would impart a discipline on governments to manage their economies in an efficient manner. There would be no cheating by printing extra dollars, Euros or pounds to make up for shortfalls or bad decisions.
Problems would be dealt with before they spiraled out of control and sacrifices would be endured in the present rather than passed on to future generations and future governments.
Even if governments refuse to use gold or gold-backed ‘dollars’ as their currency, precious metals still have a role. Currencies are often measured relative to one another. The Canadian dollar, for example, is often quoted in terms of the US dollar.
But what if both countries are devaluing their currency in an effort to solve economic problems? It may look like both are maintaining their value but the reality is that both are falling in value. In other words, both currencies are losing purchasing power, although it may not be apparent.
Like the general public, some financial advisors embrace gold and others avoid it. Investors who believe that there is some merit to investing a portion of their portfolio in gold at the appropriate time should be aware of the pros and cons of investing in the precious metal.
Investing in gold bullion can be accomplished through the purchase of physical coins or bars, through exchange traded funds or through mutual funds. The best choice will depend on the investor and their unique circumstances.
Valuation of gold
Gold may be the most difficult of all asset classes to value and that is one of the reasons why so many portfolio managers, advisors and investors stay away from it. They simply can’t get a handle on it.
Part of the problem is that gold seems to be most frequently measured against cash, bonds or equities.
A more accurate comparison may be to measure it against dollars, Euros or yen. These are all currencies, as is gold.
Dollars don’t earn dividends or interest; it is only when those dollars are lent out or used to purchase shares in a company that they earn a rate of return. The same applies to gold and that is how it should be compared.
Here is the same experiment again. Take a $100 bill and a piece of gold, put them both in a safety deposit box and open it a year later. If dollars really grew on their own, there might be a $5 bill or a $10 bill sitting next to the $100 bill. Currencies don’t earn a rate of return and gold as a currency doesn’t earn a rate of return either.
Some argue that the bank pays interest on dollars, contradicting the above argument. But a dollar deposited into a bank account is actually a loan to the bank. They turn around and lend that dollar to someone who wants to borrow it and earn a profit by charging a higher rate than they are paying.
It gets better. There is a practice that is approved by governments and central banks. It is known as fractional reserve lending. When you deposit your dollar into a bank, they loan it out not once but several times. If a significant portion of the population suddenly decided to withdraw their money from the bank they would find it wouldn’t be there. Our Canadian banks would not be immune.
The entire fractional reserve system is built on promises and trust. The example above is simply used to illustrate that dollars, left on their own, do not earn interest. Currencies are simply a tool that makes the exchange of goods and services more efficient.
Gold is another tool that serves that same purpose.
In order to accurately and objectively measure the value of a currency, it needs to be compared to a standard that does not change rather than another currency which is also changing. Once again, the characteristics of gold make it the ideal measuring stick.
There is always the temptation to discredit the measuring stick when the measurement is not as good as expected. Conspiracy theorists will say that this is exactly what is happening in the gold market.
High gold prices are an indictment of central bank monetary policy and the theory exists that some governments are trying to suppress the price of gold to save the reputation of their currency.
An obscure but simple ratio between two financial statistics is one indicator that might be helpful in determining whether or not gold is an investment worth considering. It is the ratio between short term interest rates and the inflation rate. If interest rates are lower than the rate of inflation, the environment is positive for gold; if the situation is reversed, gold is less attractive.
The logic is also simple. If interest rates are lower than inflation, the currency loses purchasing power over time, despite the fact that interest is being earned on the investment. Investors begin to look for options and gold is one of those.
Other factors can come into play as well, but being aware of the ratio between interest rates and inflation is a good place to start.
Gold is not shares in gold mining companies
It is also important to keep in mind that there is a difference between physical gold and shares in gold mining companies. One is a precious metal, while the other is an equity, and the two can react very differently to the same economic events.
NEXT: Mutual Funds and ETFs
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