HardAssetsInvestor

The Special Case For Gold

"Water is best, but, shining like fire blazing in the night, gold stands out supreme of lordly wealth."

Pindar - First Olympian Ode

Since the Greek poet Pindar described gold in these glowing terms in 476 BCE, its identification with wealth has changed very little over the ages.

Indeed, priced as it is now and viewed against both the increasingly ragged backdrop of the U.S. economy and current credit crunch, its association with wealth, secure (or "lordly") wealth, is particularly strong.

Why Buy Gold?

Three of the most fundamental reasons for buying gold are the following:

• For economic security
• For physical security
• Against contingencies

For Economic Security

Gold is an excellent long-term hedge against inflation.

In the very long term, and despite sometimes quite significant short-term price fluctuations, gold has been shown to maintain its store of value in terms of real purchasing power.¹ In other words, as the value, i.e., purchasing power, of the dollar falls (and inflation goes up), so the price of gold rises.

Unlike any of the world's currencies, each of which represents debt incurred by the relevant issuing government, gold is not a liability. And since it is not a liability, it can neither be repudiated, nor its value undermined by inflation. This stands in stark contrast to the world's paper currencies that, printed as they are, by ‘fiat,' always lose value in the long term (this can, and does, also happen in the short term.)

In addition, gold has been shown not only to provide a strong hedge against a declining dollar² (when gold is traded throughout the world it is always bought and sold in U.S. dollars, i.e., it is nominally priced in U.S. dollars), but also to be a better hedge against the dollar than other commodities.³

For Physical Security

Gold is a secure asset.

In the past, when there was a gold standard, governments banned individuals from holding gold - preventing those individuals, in effect, from holding (and preserving) their wealth beyond the control of government. As the young Alan Greenspan put it in 1966: "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold." Now, however, it can be freely held.

Held as an asset, not only is gold liquid, but it is also subject neither to the freezes nor to the imposition of exchange controls that can, at times, threaten other asset classes and currencies. As, once again, Mr. Greenspan put it back in 1966: "It [gold] stands as a protector of property rights."⁴ It has a physical security not associated with any number of other assets.

Against Contingencies

Gold is an excellent "crisis" hedge.

Undisputed worldwide as a store of value, gold can be a form of "insurance" both in times of crisis and when there are extreme untoward movements in other asset classes. For example, during the period of hyperinflation in Germany from 1918-24, gold maintained its purchasing power while the value of bonds and stocks were catastrophically diminished.

Set apart as it is from other commodities because of its acceptability, portability, homogeneity and indestructibility, the market in gold is both universal and highly liquid. You can buy and sell gold around the globe. Even James Bond in "From Russia with Love," traveled with some 50 British gold sovereigns hidden in his briefcase - just in case!

What place should it have in my portfolio?

Holding gold as a strategic asset can help you diversify your portfolio.

A long-term asset portfolio needs to be diversified. Diversification helps reduce both risk and volatility. The key to diversification is a choice of assets with returns as little correlated to each other as possible. Essentially, each of your asset classes needs to march to a different tune: Movement in one should be reflected as little as possible in the movement of any other.

Since there is little correlation (it is, in fact, low to negative) between the returns on gold and on financial assets, such as equities, gold can help provide just such diversification (i.e., when financial markets fall, the price of gold tends to rise, and vice versa).

Recent research ⁵ into the difference between gold and other assets has demonstrated that, in the long term, there is no important correlation between changes in inflation, interest rates and GDP and the returns on gold. In contrast, such macroeconomic variables are strongly correlated with returns on such financial assets as bonds and equities.

The same research has also shown that changes in such macroeconomic variables have a much greater effect on the returns on other commodities (particularly non-ferrous metals and oil) than they do on gold.

A general market decline, therefore, will not be reflected in a general decline in the price of gold. Gold will, in fact, provide protection against such declines.

In addition to reducing risk, improving a portfolio's diversification will also help to reduce its volatility. Reducing its volatility will, in turn, often result in higher compound rates of return.

While it is more usual to look at different asset classes when building a portfolio, in the case of gold, it is certainly worth considering it as an asset class in and of itself (rather than as an individual security within the commodities asset class) and, consequently, investing in it directly.

How much gold you should add to your portfolio, however, will depend upon the risk profile of your portfolio. If, on the one hand, you have a low-risk portfolio, the inclusion of gold can help enhance its performance. On the other hand, if you have a high-risk, high-return portfolio, gold's strong lack of correlation to the equity and bond markets could help bring stability in times of either economic turmoil or falling markets.

Conclusion

Since timing the market is impossible and your investment in gold is for the long run, the important thing - many people believe - is that you buy it, not when you buy it.

While the recent surge in gold prices has brought speculators into the market, and has increased the short-term correlation between equities and gold, it has done little to rattle the long-term position of the metal as a good portfolio diversifier and a safe store of value.

NEXT UP: Base Metals

Precious metals are pretty, but base metals are where the real action happens.

ENDNOTES

1. Harmston, S. (1998) Gold as a Store of Value, London, World Gold Council.
2. Capie, F., Mills, T. & Woods, G. (2004) Gold as a Hedge against the US Dollar, London, World Gold Council
3. Kavalis, N., (2006) Commodity Prices and the Influence of the US Dollar, London, GFMS Limited
4. Greenspan, A. (1966) Gold and Economic Freedom, The Objectivist.
5. Lawrence, C. (2003) Why is gold different from other assets? An empirical investigation, London, World Gold Council.

LINKS FOR MORE INFORMATION
Doug Casey: The Case For Gold
Resource Investor
Gold Investing 101