Introduction
Humans have been using gold as both a medium of exchange and a store of wealth for thousands of years. The unique characteristics of gold—its durability, malleability, and scarcity—have made it a valuable asset. Unlike paper money, the value of gold is not subject to inflation or the whims of government policy. Although the world transitioned away from the gold standard in the 1970s, gold has remained a standalone asset class, offering unique investment opportunities and a successful one at that: the chart below shows gold’s price performance since the end of the gold standard.
What Influences Gold Prices?
When it comes to understanding the fluctuations in gold prices, 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 main factors to consider: the "real" yield on government bonds, the strength of the U.S. dollar, and the overall mood among investors.
Real Yield on Government Bonds
The term "real yield" refers to the actual return you get from government bonds after accounting for inflation. In simple terms, it's the interest rate on the bond minus the rate of inflation. The price of gold often moves in the opposite direction to real yield. So, when the real yield drops, the price of gold usually goes up.
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.
Strength of the U.S. Dollar
Gold prices are quoted in U.S. dollars. So, when the dollar weakens compared to other currencies, gold becomes cheaper for people in other countries, increasing its demand. This, in turn, pushes up the price of gold. On the flip side, a stronger dollar makes gold more expensive, reducing its demand and price.
Overall Investor Sentiment
Gold is often seen as a "safe-haven" asset, meaning people turn to it during times of economic or political uncertainty. When investors are nervous, they are more likely to buy gold, driving up its price. However, when the economy is stable and investors are confident, the demand for gold may decrease, leading to a drop in its price.
Why Invest in Gold?
Investing in gold can offer several advantages, and here are some key reasons why people choose to include it in their investment portfolios:
Diversification
Gold is often considered a different asset class compared to stocks, bonds, and real estate. Adding gold to your investment portfolio can help spread the risk, making your investments more resilient during market downturns.
Inflation Hedge
Gold has historically been seen as a good hedge against inflation. When the cost of living goes up, the value of money goes down, but the value of gold often remains stable or even increases. This makes it a useful asset to have during inflationary periods.
Safe Haven
During times of economic or political instability, gold is viewed as a "safe haven" asset. Investors flock to gold when they're uncertain about the future, which can drive up its price.
Liquidity
Gold is a highly liquid asset, meaning you can easily buy or sell it. Whether you own physical gold or financial products tied to gold, you can quickly convert it into cash if needed.
Long-term Value
Gold has been valued for thousands of years and is likely to continue to be valued in the future. While its price may fluctuate in the short term, many believe that gold will maintain its value over the long term.
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.
How to invest in gold
When it comes to investing in gold, you have several options, each with its own set of advantages and disadvantages. Here are some popular methods:
Physical Gold
Pros:
You own the actual gold, which can be stored in a safe or a deposit box.
No counterparty risk, meaning you don't rely on someone else's financial stability.
Cons:
Storage and insurance costs.
Risk of theft.
Gold ETFs (Exchange-Traded Funds)
Pros:
Easy to buy and sell, just like stocks.
Lower costs compared to storing physical gold.
Cons:
You don't own the physical gold.
Counterparty risk exists, as you're relying on the financial stability of the ETF provider.
Gold Mining Stocks
Pros:
Potential for high returns if the mining company discovers more gold or increases production.
Easy to buy and sell on stock exchanges.
Cons:
Risky, as the stock price can be affected by factors other than the price of gold, like management decisions or mining issues.
Gold Futures
Pros:
Allows you to control a large amount of gold with a relatively small investment.
Can be traded easily.
Cons:
Highly speculative and risky.
Requires a good understanding of the futures market.
Gold Mutual Funds
Pros:
Managed by professionals.
Diversifies your investment across various gold-related assets.
Cons:
Management fees can be high.
Performance depends on the skill of the fund manager.
Gold Certificates
Pros:
Easy to store, as it's a piece of paper or a digital certificate.
No storage or insurance costs.
Cons:
Counterparty risk, as you're relying on the issuer's financial stability.
Not the same as owning physical gold.
Would you like to continue to the next section, which will discuss the factors that drive the price of gold?
Conclusion
While there are compelling reasons to invest in gold, it's crucial to remember that the factors driving its appeal can also work against it. For instance, gold is often seen as a hedge against inflation, but it may not perform well when inflation rates are declining. Similarly, the price of gold can suffer when bond yields are on the rise, the U.S. dollar is strengthening, or investors are more willing to take risks, moving away from traditional safe havens like gold.
Moreover, gold's reputation as a portfolio stabilizer during market downturns doesn't always hold up. During massive market selloffs, investors may be forced to sell their most liquid assets, including gold, to meet margin calls from brokers. This can lead to a temporary drop in gold prices, as witnessed during the market meltdown in March 2020.
So, while gold offers various benefits, including inflation protection and portfolio diversification, it's essential to be aware of the potential risks and market conditions that could adversely affect its performance.