What is Gold?
- What is the definition of gold?
- What are some reasons to invest in gold?
- Why is gold viewed as a hedge against inflation?
- When does market demand for gold (and its price) tend to rise?
Table of Contents
Gold Investment Definition
Gold has been a longstanding option for investors to safeguard their wealth, especially in periods of uncertainty.
Historically, gold was a medium of exchange and once backed the entire monetary system in numerous countries, including Britain and the U.S. (i.e. the “gold standard”).
Gold no longer plays a central role in the global monetary system yet remains a symbol of wealth and a valuable precious metal (i.e. “collectible”) because of its following properties:
- Diversification: Gold is not correlated to the equities and bond markets – in fact, the price of gold is considered to move inverse to that of traditional asset classes.
- Inflation Protection: The price of gold, at least in theory, is said to grow in line with the inflation rate over time.
- Currency Debasement Hedge: If a country’s currency is at risk of collapse, gold could be an escape for the country’s residents from the erosion of their home currency’s value.
- “Safe Haven” in Recession: Gold prices typically rise when the outlook on the economy is negative, and investors fear a recession is on the horizon.
- Fixed Supply: Unlike the money supply, the total gold supply in circulation is capped (and counterfeits are very difficult), which helps stabilize the price as a result of scarcity.
Interestingly, gold was formerly a monetary asset (i.e. financial value) but is now viewed as a valuable commodity, as seen by its prevalence in premium jewelry (e.g. watches, necklaces, rings), electronics, and medals for awards.
Investing in the Gold Asset Class
In times of market volatility and uncertainty, the demand (and price) of gold increases as investors view it as a secure asset class.
Hypothetically, even if the entire economy or government were to collapse, gold would retain some economic value because of its unique physical properties, scarcity, and durability.
Gold has a proven track record of value preservation and has historically been relied upon as a hedge against periods of high inflation and global recessions.
Since the price of gold is independent of the factors that affect the performance of traditional asset classes (e.g. public equities, bonds), it is the asset of choice for investors seeking to diversify their portfolios.
Negative Beta of Gold – Market Hedge
- Stock Market Rises → Price of Gold Declines
- Stock Market Declines → Price of Gold Rises
The gold asset class generally performs well when the economy is poor (or projections by economists seem grim).
Hence, if the stock market undergoes a recession or even a correction, investors often flee towards gold, which they collectively view as a “safe haven” for their capital (and the sudden increase in demand causes gold prices to increase).
Methods to Invest in Gold
There are many ways to invest in gold, such as the following:
- Physical Gold (e.g. Gold Bars, Gold Coins)
- Mutual Funds and ETFs with Gold Ownership
- Shares in Gold Mining Public Companies
- Gold Futures / Gold Options
Drawbacks to Gold Investments
Gold can diversify a portfolio and protect against volatility (i.e. swings in prices) but at the cost of giving up long-term returns.
Gold is widely viewed as a recession-proof investment, as demonstrated by how capital pours into the asset class when the markets fear a downturn.
Given gold’s historically low correlation with other asset classes, the asset class typically plays an integral role in a well-diversified portfolio and serves as a hedge against inevitable economic contractions.
But there are several drawbacks that investors should be aware of before investing in gold.
- Mediocre Returns: Gold is a safe investment with less volatility, but its historical returns have significantly trailed behind stocks and bonds.
- No Intrinsic Value: Gold does not provide any cash flows (or rights to future earnings) to the owner until the gold is sold (i.e. the seller profits if the sale price is greater than the original purchase price) – but until the investment is sold, the gold itself pays zero dividends or interest.
- Sensitivity to Bond Yields: Gold’s value tends to be highly sensitive to bond yields, as higher yields result in more competition with fixed income, especially for issuances with strong credit ratings.
The more controversial criticism of gold is that gold is quite volatile for an investment widely considered to be a safe haven.
Additionally, most investors expect the price of gold to rise when stocks decline (and decline when stocks rise), but gold at times has demonstrated a tendency to contradict that expectation and move in the same direction as the stock market.
Gold Investment vs Government Bonds
Despite its reputation as an effective hedge against inflation, one could argue that government bonds (e.g. TIPS, 10-year bonds) are just as secure because they are backed by the government (and are “risk-free”) with the potential to receive higher returns.
While the recommendation of whether to include gold in a portfolio depends on a particular investor’s objectives, the middle ground view is that a small percentage of gold should be allocated to the portfolio to benefit from the diversification benefits.
However, it is important to keep in mind that gold can still be volatile – just not to the same degree as riskier assets.
The difference is that gold has been shown to remain resilient and return to a baseline price even after long periods of underperformance (or volatility).
Although an “imperfect” hedge, gold remains one of the best options for mitigating market risk.
Gold Price Example (Inflation Fed Rate Hike, Ukraine/Russia)
In 2021, U.S. inflation reached 7%, setting the stage for Fed hikes – however, despite the sharp rise in inflation, the price of gold did not increase dramatically.
After about two years of unprecedented Fed policies towards interest rates and quantitative easing (QE), the annual growth in the consumer price index (CPI) was at the highest level in close to four decades.
With declining unemployment rates and optimism around a return to normalcy, many have speculated the Fed would soon raise interest rates, which was confirmed in March 2022.
Jerome Powell signaled his intention for a 25 basis-point increase on the benchmark interest rate (and with more likely to follow later in the year).
Gold notched its largest annual decline since 2015, dropping by approximately 4% as global economies recovered from the COVID pandemic and demand for the precious metal weakened.
Gold Historical Price Data (Source: Goldhub)
The potential for rising interest rates and a strong U.S. dollar place pushed gold prices down, even during a year of record-high inflation.
Yet after a dismal year, gold reversed its declines following Russia’s invasion of Ukraine and could even reach new highs (~$2,100 per ounce), illustrating how geopolitical tension and fears of inflation can drive up the demand (and price) of gold.