When it comes to gold, perspectives vary and emotions run high. The differing opinions expressed in each of the quotes above hints at an aspect of this unique yellow element. What is gold? Why is it such an apparently controversial topic? What purpose does it have in an asset portfolio? In short, why does gold matter? This missive seeks to answer these questions in plain English.
Gold is Money
Money is defined as a store of value, a unit of measure, and a medium of exchange. Throughout all of recorded history gold has fulfilled this definition of money. Gold is the treasure of Solomon, the money of kings, the first object of loot in war, and the principle goal of both pirates of the Spanish Main and modern day shipwreck expeditions. Gold is money in every sense of the word...and always has been.
Of course, there have been, and are today, many other forms of money. Shells, stone disks of various sizes, silver and copper coins, cattle, horses, paper, land, and even electronic 1s and 0s in the modern case of Bitcoin. What we usually think of as money today, namely dollars, euros, francs, pounds, and the like, are considered fiat currencies, meaning that they are assigned their value by governments requiring taxes to be denominated and paid in kind.
There are likewise many means of storing and accumulating wealth that sometimes look very much like money. For example, US government bonds have relatively consistent value and can be exchanged for other items of value. Similarly, one could think of a piece of real estate property, or a share of General Electric stock as something having value, and having the potential to be exchanged for something else of value. Even credit in its purest form, a person's promise to give value in the future, can be thought of similarly to money. Credit can be used to buy a car, and then that same loan can be bought and sold between banks.
But let's not stray too far from our topic. The point is that there are many things that have money-like characteristics, but gold is only money and nothing else. True, gold is also shiny, makes nice jewelry, and has a few industrial uses due to its electrical and thermal characteristics. However, to consider these aspects of gold is to cloud our perspective as investors, because gold derives nearly all of its value due to its "money-ness". So for our purposes we should see gold as simply money. It generates no income, it carries no accompanying liability, it just sits there being gold today, tomorrow, and for the next thousand years...and that is exactly its value.
Inversely Comparable Valuation
Okay, so gold is money, but what makes gold more or less valuable as measured against other assets and forms of money? Answering this question also explains the strong, and often conflicting statements of opinion about gold. Gold's value varies as its desirability relative to other forms of assets varies. Said another way, gold is the denominator of a relative relationship between assets. At the time of this writing, gold is priced at a bit more than $1200 per Troy ounce. Specifically, the dollar price of gold will go up if either gold becomes more relatively attractive or if the dollar becomes less relatively attractive.
As we've discussed, gold's essence doesn't change. It is what it is. Therefore, when the "price" or "value" of gold appears to increase, what is actually occurring is that the relative value of alternative assets is decreasing. Understanding this, we can see the reason behind the intensity of the various opinions on gold. The price of gold is the definition of a zero-sum game. Gold is either losing value because other assets are gaining more and more attraction and investor attention, or gaining value because other assets are losing their appeal. Since gold is currently, by most estimates, substantially less than 1% of the total value of the worlds assets, it should be no surprise that in the aggregate there are many more investors and market commentators hoping for and "rooting" for the future value of those other assets than for gold. This is especially typically true for many of those in the financial business whose living depends on the increasing value of alternatives to gold.
Warren Buffett's comment on gold is also an important one, and is not as disparaging as it appears on first glance. He isn't disputing that gold IS wealth. He's merely pointing out that is isn't an asset that PRODUCES wealth. As perhaps the greatest selector of wealth producing assets in history, he has both a valid point, and an understandably biased perspective. Financial theory states that it is accepting risk that produces return. While companies that mine gold certainly are both risky and expected to produce investor returns, gold itself is a return-free asset. As Buffett says, it just sits there.
Reserve Currency of Last Resort
In recent decades, gold has drawn the public scorn of central bankers around the world, but less than fifty years ago gold was directly tied to the value of the US dollar. Until the 1930’s, the US Dollar was freely interchangeable with gold at the set price of $20.67 per troy ounce. During the only deflationary environment in the 20th century at the heights of the Great Depression, Franklin D Roosevelt devalued the dollar against gold via the Gold Reserve Act of 1934, increasing the nominal price of gold to $35 per troy ounce. This new price enticed foreign investors to export their gold to the United States and simultaneously devalued the dollar creating inflation.
While Roosevelt’s actions forbade US private ownership of gold, the dollar’s international convertibility was maintained at the $35 per ounce level until 1971. As inflationary pressures rose and the dollar’s value declined during the 1960’s international dollar holders, led by Charles de Gaulle, increasingly demanded redemption of their dollars in gold. As US gold holdings declined precipitously, in 1971, President Richard Nixon declared that the United States would no longer honor the exchange of dollars into gold at the official rate. While this was intended to be temporary, inflation persisted and the dollar to gold exchange rate was raised first to $38, then to $42.22, before finally being allowed to float as a market traded contract on the New York and Chicago exchanges in 1975.
Gold’s ongoing importance as an international reserve currency is underlined in recent years with China’s central bank purchases drawing intense media and investor attention (PBOC). China wants its currency, the Yuan, to enjoy the benefits of reserve currency status. A key component of this is the status a reserve currency gains by being unofficially backed by the issuing country’s gold holdings. China currently only officially holds a bit under 2% of its current reserves in gold. Increasing these holdings into the 5-10% range would have substantial effect on the real and perceived strength of its currency as a global reserve currency.
While monetary history and the study of international currency movements can be dry, the importance of gold on the macro level of the global economy and the trade and political relationships between countries cannot be overstated. Gold gives strength to a countries’ currency which lowers borrowing costs, and increases that country’s economic power. Two thirds of the familiar term “cold hard cash” is owed to characteristics of the yellow seventy-ninth element.
Gold plays a critical role as a diversifying asset in a properly optimized portfolio. The specific stated goal of a diversified portfolio is to reduce risk while acknowledging that such risk reduction is necessarily accomplished by also reducing return to some extent. Where possible, we want to reduce risk by negative correlation rather than by low positive correlation. Simply an asset that tends to move in the inverse to other assets in a portfolio has more "diversification value" than an asset that simply moves independently of other assets in a portfolio. As such gold has few peers due to its very nature. Its value is both derived and defined by its relative value versus other investment alternatives.
We can also take a broader and less technical perspective on gold in our portfolios is to consider it as insurance on our other assets. Just as buying life insurance is often quite advisable in many circumstances, so is buying golds "portfolio insurance". As investors we look to acquire this unique asset when the risk-return ratio is favorable. While we can legitimately hope to never realize the full value of such insurance, we can certainly appreciate the increased stability of our portfolios during volatile markets.
Critics sometimes point to the volatile and sometimes seemingly random nature of golds price moves as a weakness. Gold’s volatility can be explained best by two facts. The first that it is a relatively small percentage of total financial assets at well under 1%. It doesn’t take a large capital shift to dramatically affect its price. In addition to this, gold is the one asset that responds to both fear and greed. This positive feedback tends to drive exaggerated moves. Former Fed Chairman Ben Bernanke once stated the “Nobody really understands gold prices and I don’t pretend to understand them either”. Of course, his seeming ignorance was followed with the observation that a declining gold price “suggests people have somewhat more confidence and are less concerned about really bad outcomes”. Exactly! And Bernanke’s predecessor, Alan Greenspan recently reiterated his view that gold is profoundly important to reducing currency risk. We agree. Since other assets in a portfolio are denominated in dollars (or euros, or yen), it makes sense to own an asset that directly insures against the denominator’s loss of value.
What is gold and why does it matter? Gold is money. Always has been, probably always will be. It is often an emotional due to the implications of its essence as an asset. Gold often moves counter to the value of, and faith placed in, other investment options. To say this another way, gold often goes up when “other stuff” goes down. Gold owners and “other stuff” owners aren’t often happy at the same time. Of course, this is exactly gold’s primary value to us from a portfolio standpoint. We seek asset classes with negative correlation since this allows an overall reduction in portfolio risk without proportional reduction in overall expected returns. Gold is simply ultimate currency in unchanging and possessable form. A portfolio anchor in a world of increasing economic correlation, cross-currents, and complexity.
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