Gold as an investment

Gold is one of the world’s oldest assets and it continues to inspire potential investors. There is a common desire to possess gold, but is it really a good investment? Let’s take a look at the long-term investment potential for gold and compare it with some alternatives.

Protecting against inflation

Perhaps gold is best known for maintaining its value over the long-term. There has been a steady, worldwide demand for this metal throughout human history. This constant demand powers gold’s ability to maintain value in an environment when prices are rising.

Economists define a currency by three essential traits: Medium of Exchange, Unit of Account, and Store of Value. Gold can serve the all the functions of a currency. Unlike fiat currencies, however, there is a limited supply of gold, so its value can never be diluted by creating new currency.

Medium of Exchange: Gold is a physical object which can be transferred between parties

Unit of Account: Gold is countable based on its weight and purity

Store of Value: Unlike many other commodities, gold does not spoil over time

Gold’s value as a commodity

Aside from being an ancient form of money, gold does indeed have some industrial uses as a commodity. Gold is used in the manufacture of electronics and, unsurprisingly, luxury goods. However, the amount of gold used in manufacturing is minimal.

Based on correlations in broader markets, our view is that gold behaves more like a pseudo-currency than an industrial commodity. Because gold is similar to a currency, it is often more liquid than other kinds of commodities. This means that most of the time it’s easy to find a buyer or seller of gold. Sometimes commodities become illiquid when storage costs are high or in response to big swings of supply or demand.

Safety in an emergency

Because gold is known as a price-stable asset, people tend to buy it during highly uncertain times. When even the stability of cash is at question, gold may provide the safety to weather a severe economic storm. Of course, it takes more than an ordinary emergency for investors to lose faith in cash as a safe asset. Gold is worth consideration when facing a global-scale event, like a world war. Although, in such an event, many investors might need to focus on securing their physical safety before worrying about their investments.

Alternatives to gold

Other commodities

There are many other tradable commodities besides gold. Oil and other energy products are perhaps the best known example, but there are many other commodities used in agriculture, mining, and other industries. Theoretically, holding a portfolio of several different commodities would hedge against price inflation. Diversifying across several different commodities would reduce the risk of loss by spreading exposure out across different sectors.

However, many commodities must be used before spoiling and several incur significant storage costs. These factors make commodities less appealing as long-term investments.

Gold mining stocks

Another alternative is to invest in gold mining company stocks. Presumably, their profits should be tied to the price of gold and therefore provide the same benefits while avoiding some of the drawbacks (such as storage costs). However, for a variety of reasons, gold mining stock prices have drastically underperformed the price of gold in recent years.

A chart showing GDX underperforming GLD since 2007

In the above chart, GLD (orange) is an ETF that tracks the commodity price of gold, while GDX (blue) is an ETF that holds gold mining stocks.

A managed stock portfolio

Now, let’s look at the classic long-term investment, a diversified portfolio of stocks, which also happens to be our specialty.

Traditionally it is thought that inflation harms businesses and therefore stocks. Economists have proposed several mechanisms to explain why, for example Menu Costs. The 1974 recession was driven by inflation, and stocks underperformed. At the time, more of the United States economy was based on manufacturing, and energy (i.e. crude oil) was necessary for industrial production. But economists also point out that, in the long run, inflation has a neutral effect on the value of businesses and this has proven true. Not to mention that today’s economy is structurally different and can adapt to changing prices very quickly.

Perhaps the biggest advantage of stocks over gold or any other commodity is that they are businesses. Businesses grow with the economy and reinvest in themselves. Any investment which grows at a constant rate yields compound returns. Trading commodities, on the other hand, has been described as a zero-sum game. Their prices rise and fall rather than continuously growing. Warren Buffett sums it up best in this quote about gold: “It doesn’t do anything but sit there and look at you.”

Comparison

  Gold futures or ETFs Commodities portfolio Gold mining stocks Stock portfolio
Protects against inflation
Generates income
No storage costs
Diversity across sectors
Safe in an emergency
Liquidity
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