The real value of gold is not that it provides a quick, speculative fix, but that it can provide a sure and steady means of protecting wealth and enhance the consistency of returns.
With gold’s role as a portfolio diversifier, a hedge against inflation and exposure to the dollar, there are several compelling arguments for investing a portion of one’s portfolio in the yellow metal.
Most investment portfolios are invested primarily in traditional financial assets such as stocks and bonds. The reason for holding diverse investments is to protect the portfolio against fluctuations in the value of any single asset class. Portfolios that contain gold are generally more robust and better able to cope with market uncertainties than those that don’t.
Adding gold to a portfolio introduces an entirely different class of asset. Gold is unusual because it is both a commodity and a monetary asset and is an effective diversifier because its performance tends to move independently of other investments.
Independent studies have shown that traditional diversifiers such as bonds often fail during times of market stress or instability. Even a small allocation of gold has been shown to significantly improve the consistency of portfolio performance during both stable and unstable financial periods. Gold can improve the stability and predictability of returns. The performance of gold is not correlated with other assets because the gold price is not driven by the same factors that drive the performance of other assets.
Gold is often cited as being an effective hedge against fluctuations in the US dollar, the world’s main trading currency. If the dollar appreciates, the dollar gold price falls and similarly a fall in the dollar relative to the other main currencies produces a rise in the gold price.
In a recent study by leading metals consultancy GFMS Ltd, the strength of the link between twenty-two commodities and the US dollar was examined. The results clearly suggested that not only is gold a more potent hedge against the dollar than other commodities, but also that protection is provided when most needed (when the dollar is losing value), with relatively little upside foregone during a period of dollar appreciation.
Like all physical commodities, gold is an asset that bears no credit risk. Holding assets in the yellow metal involves no counterparty and is no one’s liability. In addition to that, the physical properties of the metal make it an excellent alternative to money.
Gold is durable. Unlike many of the other commodities examined, other things remaining equal (i.e. assuming no changes in price), there is no depreciation in the value of gold, other than any storage costs that might apply. Gold is fungible. It is, at least in theory, infinitely divisible with virtually no losses (other than any operational costs the process might incur).
Furthermore, gold has a high value to volume ratio, which makes it easily transferable, with low transport and storage costs. Moreover, gold is one of the deepest commodity markets with the highest levels of liquidity, second only to oil.
The purchasing power of gold has not diminished since Biblical times. According to the Old Testament, during the reign of King Nebuchadnezzar, an ounce of gold bought 350 loaves of bread. Today, an ounce of gold still buys 350 loaves.
The value of gold therefore, in terms of real goods and services that it can buy, has remained remarkably stable. In contrast, the purchasing power of many currencies has generally declined. There is a growing body of research to bolster gold’s reputation as a protector of wealth against the ravages of inflation. Market cycles come and go, but gold has maintained its long term value.
So gold is often bought to counter the effects of inflation and currency fluctuations. In fact extensive research from a range of economists has consistently shown that, in spite of price fluctuations, gold has consistently reverted to its historic purchasing power parity; and during periods of financial, economic and social turmoil, gold has been a safe refuge when the value of other assets was all but destroyed.
In volatile and uncertain times, we often witness a ‘flight to quality’, as investors seek to protect their capital by moving it into assets considered to be safer stores of value.
Gold is among only a handful of financial assets that is not matched by a liability. It can provide insurance against extreme movements on the value of traditional asset classes that can happen in unsettled times.
Some recent examples of the refuge afforded by gold include:
In 1997/98 the Government of South Korea asked its citizens to allow it to buy their gold holdings in exchange for local currency debt instruments. The Government raised over five million ounces of gold in this way which it sold for hard currency. As a result it was able to service its external debt.
Fearful of the implications of the forecast electronic and communications disaster surrounding Y2K, there was a flight to gold in 1999.
The first quarter of 2002 saw a flight to gold by Japanese investors as they awaited the withdrawal of government guarantees on bank deposits.
Gold’s liquidity is one of its critical investment attributes. Gold can be traded around the clock in larger size, at narrower spreads and more rapidly than many competing diversifiers or mainstream investments.
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