Why buy gold?

The case for gold

Events in the past several years have alerted everybody to the risks in today’s modern financial systems. The new millennium started off with the bursting of the new economy bubble and a massive destruction of shareholder value. The burst was followed by a recession in most Western economies like the US and the UK. As a reaction, Western central banks, led by the US Federal Reserve Bank (FED) lowered interest rates and virtually created a liquidity flood on the market in the form of cheap money. This liquidity facilitated a return to economic growth in the Western economies but also laid the foundation for the next crisis, the mortgage crisis, which quickly developed into a general financial and economic crisis. The financial and economic crisis have led to the sovereign debt crisis.

Many investors view gold as a safe haven, a counter-cyclical investment to help balance losses in other asset classes in times of stress and an insurance asset in case of a big crisis.

In the following paragraphs we analyze key characteristics of gold investments and list arguments for and against investing in gold to answer the question of why to invest in gold – making the case for gold.

The return on gold

In contrast to many other investments, investments in gold do not yield a regular return in the form of dividends or interest. Gold investments share this characteristic with investments in other commodities and precious metals.

Investors in gold only profit from value appreciation, i.e. a rising gold price leads to a return on the gold investment. The value appreciation of gold can be significant. In terms of US-Dollars, the price of gold rose from below 300 US-Dollars per ounce in 2001 to more than 1,500 US-Dollars in 2011. In that same period, the price of gold in British Pounds also rose by about 400%.

The future return on gold cannot be extrapolated from historical returns, but there are several arguments supporting a further increase in the price of gold due to fears of inflation or a return of the financial crisis. See our overview of gold price forecasts by renowned analysts.

Protect value with gold investments

For many investors, the main purpose of investing in gold is not primarily the possibility of the gold appreciating in value but to preserve the money invested. Gold investments often perform well in economically difficult times or during crises. Comparatively, most other asset classes or investments lose in value under such circumstances.

The price of gold may decrease, but unlike asset classes such as currencies, stocks, shares, bonds or other securities, physical gold will never completely lose its value.

Gold investments to diversify portfolios

The low correlation of the gold price with the prices of other asset classes make gold investments an attractive instrument to diversify investment portfolios. Modern investment theory would suggest that investors add assets with low or preferably negative correlation to their portfolios in order to improve the risk-return profile.

Gold and inflation / deflation

Physical gold investments are backed by gold as generally opposed to paper-securities or “paper gold”. Unlike currencies, debt instruments or stocks/shares, the amount of gold is limited. Governments can print more money, but nobody can create gold.

This characteristic led to the relative stability of gold in terms of purchasing power. Around the year 1900, 1 ounce of gold could buy a nice suit. That same ounce of gold could still be used to purchase a suit of similar value today. Compare this to the dramatic loss of value in all the major currencies over long periods of time. One US-Dollar or British Pound today has only a fraction of the value that it had in 1900. There are different methods to calculate the worth (see Measuring Worth). In periods of high inflation, gold has often performed well. Interestingly, gold investments also tend to retain their worth in periods of deflation. The reasons for this are that in deflationary periods, other asset classes often offer lower returns or losses while gold investments are viewed as a protection or safe haven. This is why many people invest in gold to protect against both high inflation and deflation as well as other crises.

See the video ‘The impact of inflation and deflation on the case for gold’ from the World Gold Council:

 

Gold for retirement purposes

The characteristics of gold investments to protect value through diversification, to maintain a relatively stable purchasing power and to increases in value through times of economic uncertainty or stress make gold a smart investment for retirement and pension purposes.

Gold for retirement and gold as a pension asset have gained in importance over the last years amid the prevailing uncertainty and scandals caused by Enron, Bernie Madoff, etc. which resulted in numerous people losing their pension assets.

Over the last years, e.g., governments in the UK and the US supported the role of gold for retirement purposes. Citizens in the UK can now use Self Invested Personal Pensions (SIPP) to invest in gold with favourable tax treatment.

Individual Retirement Accounts (IRA) now allow people in the US to invest in gold while receiving tax advantages.

Gold as insurance

For many investors, gold’s characteristic to protect value make it an insurance asset. Gold often performs especially well in times of high uncertainty, inflation or deflation. This characteristic makes gold a suitable hedge against such scenarios. The typical investor is predominantly invested in stocks, mutual funds, bonds and cash. In times of high inflation, bonds and cash show low performance, and gold can balance those assets. Conversely, stocks, investment funds and mutual funds typically perform poorly in times of deflation, whereas investments in gold, cash and bonds tend to increase in value.

 

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