Why Gold is Necessary

Given the severe economic disruptions of the past two years, investors have been switching away from equities and into alternate asset classes, such as cash, bonds and commodities. Gold has been arguably the most sought after class, resulting in a price rise of 144% since late 2005.

Investors have been buying gold for a number of reasons. The most prominent at the moment is the risk of future inflation as a result of the huge increases in money supply the US Federal Reserve has provided. The printing presses have been running non-stop since the onset of the financial crisis. That's like plugging the sink and leaving the tap on - things get pretty murkey pretty quickly.

The effect of printing money at a rapid rate is to devalue currency already in existence. If a particular good costs $1, and there is only $1 in circulation in the economy, then the value of the good is $1. However, if suddenly another dollar appears that was created by the government, the original dollar is actually worth less. The result is that the $1 good is now worth, on a relative basis, more than the nominal $1 it was purchased for previously.

To protect against this decline, investors buy gold as a “store of wealth”. Gold is unlike any other currency in the world as its value is not strictly determined by supply and demand, but rather by its protective value against inflation and weakening currencies. On buying gold as an investment, Warren Buffett once said, “We spend huge amounts of money digging it up from underground. Then we spend huge amounts of money storing it back underground and pay men with guns to protect it. People looking down from Mars would be baffled”.

Gold is also regarded as a protection against bank failures: when dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around notes. Another reason is protection against low or negative real interest rates: If it is expected that the return on other asset classes like bonds and equities will not compensate for risk and inflation then demand for gold increases. Gold is also favored as an investment when wars, invasion or crises occur. More reasons are provided by the self-advocating World Gold Council here.

While gold may appear to be highly priced right now, on a relative basis it’s actually nowhere near it’s all time high. The gold price does not take inflation into account, which is somewhat bizarre as gold protects mainly against inflation! According to Bianco Research, gold was at $819 in 1974 in inflation-adjusted dollars, compared to $1041 today. That’s a 27% return over 36 years, or 0.66% compounded annually. A standard savings account will get you more with zero risk.

Research has shown that gold has not actually increased in value relative to inflation, presenting a very poor investment case:

So what is an investor to do?

In my opinion, gold is a necessary part of an investor portfolio, but not for any of the reasons you might think. I agree with well-known French investor Jean-Marie Eveillard who says, “I believe a small position in gold always makes sense. Not gold as trading opportunity or even an investment opportunity, but gold as the ultimate hedge or insurance”. Given the calamity of the past two years, with a total evaporation of credit and cash, and with massive and unprecedented government intervention, this insurance-policy stance holds true. The point is that it’s irrelevant at what price you buy gold because it’s the ultimate insurance policy, and not something you are looking to profit from. It’s something you are looking to fall back on. If gold is necessary, then the entire value of your portfolio will have been wiped out anyway, resulting in a massive rise in the price of gold. It may seem totalitarian and fantastical, but few people realize how close we came in 2008.

So, buy gold as insurance. Other than that it’s a very lousy investment!