(Investopedia) - Gold. It's shiny, metallic, and melts easily into bars, coins, or jewelry. It doesn't rust, corrode, or decay. Gold is ... well, golden. But why is gold so valuable, both in our mind's eye and in reality as a global store of value and medium of exchange?
Why is silver relegated to a distant second place, and what about poor old copper, which shares many of the same physical attributes as gold? Learn more about the answers to these questions, and much more.
KEY TAKEAWAYS
- In the articles that follow, we will take a look at gold's place in our economy and try to uncover just why it's valuable and what role gold can play today in investors' portfolios.
- In fact, by some accounts, gold has never been more fashionable as an alternative investment, able to weather financial crises and hedge against the inflationary pressures of fiat currency.
- We discuss the risks and opportunities of owning gold as an investment, how to try to make quick profits day trading the metal in the commodities market, what influences its price, and how to go about owning gold in your brokerage account.
Gold as an Investment
Before jumping on the gold bandwagon, let us first put a damper on the enthusiasm around gold and examine some reasons why investing in gold poses some fundamental issues.
The main problem with gold is that, unlike other commodities such as oil or wheat, it does not get used up or consumed. Once gold is mined, it stays in the world. A barrel of oil, on the other hand, is turned into gas and other products that are expended in your car's gas tank or an airplane's jet engines. Grains are consumed in the food we and our animals eat. Gold, on the other hand, is turned into jewelry, used in art, stored in ingots locked away in vaults, and put to a variety of other uses. Regardless of gold's final destination, its chemical composition is such that the precious metal cannot be used up—it is permanent.
Because of this, the supply-demand argument that can be made for commodities such as oil and grains doesn't hold so well for gold. In other words, the supply will only go up over time, even if demand for the metal dries up.
History Overcomes the Supply Problem
Like no other commodity, gold has held the fascination of human societies since the beginning of recorded time. Empires and kingdoms were built and destroyed over gold and mercantilism. As societies developed, gold was universally accepted as a satisfactory form of payment. In short, history has given gold a power surpassing that of any other commodity on the planet, and that power has never really disappeared.
The U.S. monetary system was based on a gold standard until the 1970s.1 Proponents of this standard argue that such a monetary system effectively controls the expansion of credit and enforces discipline on lending standards because the amount of credit created is linked to a physical supply of gold. It's hard to argue with that line of thinking after nearly three decades of a credit explosion in the U.S. led to the financial meltdown in the fall of 2008.
From a fundamental perspective, gold is generally viewed as a favorable hedge against inflation. Gold functions as a good store of value against a declining currency.2
Investing in Gold
The easiest way to gain exposure to gold is through the stock market, via which you can invest in the shares of gold-mining companies. Investing in gold bullion won't offer the leverage you would get from investing in gold-mining stocks. As the price of gold goes up, miners' higher profit margins can boost earnings exponentially. Suppose a mining company has a profit margin of $200 when the price of gold is $1,000. If the price rises 10%, to $1,100 an ounce, the operating margin of the gold miner goes up to $300—a 50% increase.
Of course, there are other issues to consider with gold-mining stocks, namely political risk (because many operate in developing nations) and the difficulty of maintaining gold production levels.
The most common way to invest in physical gold is through an exchange-traded fund (ETF) like the SPDR Gold Shares (GLD), which simply holds gold.
When investing in ETFs, pay attention to net asset value (NAV), as the purchase price can at times exceed NAV by a wide margin, especially when the markets are optimistic.
A list of gold-mining companies includes Barrick Gold Corp. (ABX.TO), Newmont Corp. (NEM), and Agnico Eagle Mines Ltd. (AEM), among others. Passive investors who want great exposure to the gold miners may consider the VanEck Vectors Gold Miners ETF (GDX), which includes investments in all the major miners.
Alternative Investment Considerations
While gold is a good bet on inflation, it's certainly not the only one. Commodities in general benefit from inflation because they have pricing power. The key consideration when investing in commodity-based businesses is to go for low-cost producers. More conservative investors would also do well to consider inflation-protected securities like Treasury Inflation-Protected Securities, or TIPS. The one thing you don't want is to be sitting idle—in cash, thinking you're doing well—while inflation is eroding the value of your dollar.
Gold Price Performance
The price of gold depends on a complex array of factors. Because gold is priced in dollars, the value of the U.S. currency can have a significant impact on the performance of the precious metal. A strong dollar makes gold more expensive for buyers in other countries, potentially leading to lower gold prices. On the other hand, a weaker dollar makes gold more affordable for international purchasers and may bring increased prices. Since gold is seen as a hedge against inflation, the decline in value of fiat currencies and the market's expectations surrounding inflation can also affect gold prices.3
These factors seem to be evident in the yellow metal's recent price history. Throughout most of 2022, despite soaring levels of inflation, gold prices actually dipped, likely driven lower by sustained strength in the dollar against other currencies. More recently, with inflation remaining stubbornly persistent despite the Federal Reserve's attempts to bring it under control, gold prices have recovered to more than $1,875 per ounce in January 2023, from around $1,656 per ounce in September 2022.3
What's to Come
You can't ignore the effect of human psychology when it comes to investing in gold. The precious metal has always been a go-to investment during times of fear and uncertainty, which tend to go hand in hand with economic recessions and depressions.
In the articles that follow, we examine how and why gold gets its fundamental value, how it's used as a form of money, and which factors subsequently influence its price on the market—from miners to speculators to central banks. We will look at the fundamentals of trading gold and what types of securities or instruments are commonly used to gain exposure to gold investments. We'll look at using gold both as a long-term component of a diversified portfolio and as a short-term day trading asset. We'll look at the benefits of gold but also examine the risks and pitfalls and see if it lives up to the "gold standard."
What Makes Gold Valuable?
Aside from its literal shine and the symbolic relationship with wealth that has lasted throughout human civilization, gold plays an important role as a store of value and a medium of exchange. Unlike other commodities, gold does not get used up or consumed, imbuing the precious metal with a sense of everlasting value. Gold serves as a hedge against the declining value of currencies through inflation, which leads many investors to consider gold an alternative asset and a way of safeguarding their wealth.
What Is the Gold Standard?
Under the gold standard, the value of a currency is pegged to the value of gold. The Bretton Woods Agreement, which formed the framework for global currency markets starting at the end of World War II, established that the U.S. dollar was convertible to gold at a fixed rate of $35 per ounce, with other world currencies valued in relation to the dollar.4 President Nixon ended the convertibility of the dollar to gold in 1971, signaling the end of the gold standard.
How Can I Invest in Gold?
There is a wide variety of options for investors who want exposure to gold. It's possible to invest directly in gold bullion, although the costs of storing and insuring physical gold can be significant. Investors also can turn to exchange-traded funds (ETFs) that hold the precious metal or purchase shares of mining companies whose stock prices are correlated to gold's price performance.
The Bottom Line
Gold has held a special place in the human imagination since the beginning of recorded time. From an investment perspective, gold is attractive because of its potential to remain strong in difficult financial environments and to hedge against inflationary declines in the value of fiat currencies.
Although the U.S. dollar and other world currencies are no longer pegged to gold—as was the case when many countries operated under the gold standard—the precious metal continues to play an important role in the global economy.
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By MICHAEL BROMBERG
Reviewed by MICHAEL J BOYLE
Fact checked by DIANE COSTAGLIOLA
January 12, 2023
