Gold has been mined for thousands of years and has evolved from being used primarily as a medium of exchange and jewellery to finding its way into newer technologies. The yellow metal has come a long way and is now one of the most valuable modern commodities. But what makes gold so expensive that one ounce sells for a whopping $1,200 today?
Over time, humans began using the precious metal as a way to facilitate trade and accumulate and store wealth. In fact, early paper currencies were generally backed by gold, with every printed bill corresponding to an amount of gold held in a vault somewhere for which it could, technically, be exchanged (this rarely happened). This approach to paper money travelled well into the 20th century. Nowadays, modern currencies are largely fiat currencies, so the link between gold and paper money has long been broken. However, people still seem to love the yellow metal.
To start, gold is a rare element that's hard to extract from under the ground, where it's usually found. The World Gold Council says it's easier to find a 5-carat diamond than a 1-ounce gold nugget. Gold is also one of the most malleable, soft, and ductile metals, which means it can be stretched, hammered, and molded into any shape without breaking. This largely explains why gold is the most sought-after jewellery material. Globally, jewellery accounts for nearly half of the total demand for gold.
Commercially, gold's high thermal conductivity and resistance to corrosion, among other chemical characteristics, make it a crucial input in several industries, especially electronic components, medicine (particularly dentistry), aerospace, and glass making. Central banks across the globe also hold tons of gold in reserves. Given gold's scarcity and vast variety of uses, owning gold in some form is a prudent investment decision.
Where does demand for gold come from?
The largest demand industry by far is jewellery, which accounts for around 50% of gold demand. Another 40% comes from direct physical investment in gold, including that used to create coins, bullion, medals, and gold bars.
Investors in physical gold include individuals, central banks, and, more recently, exchange-traded funds that purchase gold on behalf of others. Gold is often viewed as a “safe-haven” investment. If paper money were to suddenly become worthless, the world would have to fall back on something of value to facilitate trade. This is one of the reasons that investors tend to push up the price of gold when financial markets are volatile.
Since gold is a good conductor of electricity, the remaining demand for gold comes from industry, for use in things such as dentistry, heat shields, and tech gadgets.
Why invest in gold?
Gold is respected throughout the world for its value and rich history, which has been interwoven into cultures for thousands of years. Coins containing gold appeared around 800 B.C., and the first pure gold coins were struck during the rein of King Croesus of Lydia about 300 years later. Throughout the centuries, people have continued to hold gold for various reasons. Societies, and now economies, have placed value on gold, thus perpetuating its worth. It is the metal we fall back on when other forms of currency do not work, which means it always has some value as insurance against tough times. Below are eight potential reasons to own gold today.
Why should gold be the commodity that has this unique characteristic? It has a long history as the first form of money. It then became the base for the gold standard which set the value for all money. For this reason, gold confers familiarity. It creates a feeling of safety as a source of money that will always have value, no matter what.
1. A History Holding Its Value
Unlike paper currency, coins or other assets, gold has maintained its value throughout the ages. People see gold as a way to pass on and preserve their wealth from one generation to the next. Since ancient times, people have valued the unique properties of the precious metal. Gold does not corrode and can be melted over a common flame, making it easy to work with and stamp as a coin. Moreover, gold has a unique and beautiful color, unlike other elements. The atoms in gold are heavier and the electrons move faster, creating absorption of some light; a process which took Einstein's theory of relativity to figure out.
2. Weakness of the U.S. Dollar
Although the U.S. dollar is one of the world's most important reserve currencies, when the value of the dollar falls against other currencies as it did between 1998 and 2008, this often prompts people to flock to the security of gold, which raises gold prices . The price of gold nearly tripled between 1998 and 2008, reaching the $1,000-an-ounce milestone in early 2008 and nearly doubling between 2008 and 2012, hitting around the $1800-$1900 mark. The decline in the U.S. dollar occurred for a number of reasons, including the country's large budget and trade deficits and a large increase in the money supply.
Gold is inversely correlated to the U.S. dollar. Because gold is priced in dollars, its value increases when the dollar contracts. Bullion and the U.S. dollar have a long history of trading inversely. In fact, gold often outperforms most major currencies on an annual basis.
3. Inflation Hedge
Inflation is historically good for gold. Gold has historically been an excellent hedge against inflation, because its price tends to rise when the cost of living increases. Inflation eats away at cash and Treasury yields, making them less attractive as safe haven assets, which then leads many investors to gold.
Over the past 50 years investors have seen gold prices soar and the stock market plunge during high-inflation years. This is because when fiat currency loses its purchasing power to inflation, gold tends to be priced in those currency units and thus tends to arise along with everything else. Moreover, gold is seen as a good store of value so people may be encouraged to buy gold when they believe that their local currency is losing value.
Hedges are investments that offset losses in another asset class. Many investors buy gold to hedge against the decline of a currency, usually the U.S. dollar. As a currency falls, it creates higher prices in imports and inflation. As a result, gold is also a defense against inflation.
For example, the price of gold more than doubled between 2002 and 2007, from $347.20 to $833.75 an ounce. That's because the dollar's value as measured against the euro fell 40% during that same period.
In 2008, despite the financial crisis, some investors continued to hedge against a dollar decline. For 15 days after a crash, gold prices increased dramatically. Frightened investors panicked, sold their stocks and bought gold. After that, gold prices lost value against rebounding stock prices. Investors moved money back into stocks to take advantage of their lower prices. Those who held onto gold past the 15 days began losing money.
4. Deflation Protection
Deflation is defined as a period in which prices decrease, when business activity slows and the economy is burdened by excessive debt, which has not been seen globally since the Great Depression of the 1930s (although a small degree of deflation occurred following the 2008 financial crisis in some parts of the world). During the Depression, the relative purchasing power of gold soared while other prices dropped sharply. This is because people chose to hoard cash, and the safest place to hold cash was in gold and gold coin at the time.
5. Geopolitical Uncertainty
Gold retains its value not only in times of financial uncertainty, but in times of geopolitical uncertainty. Just as investors flock to bullion during financial instability, many also do so in times of rising world tensions and geopolitical turmoil. For this reason gold is sometimes called the “crisis commodity” and its price often appreciates the most when confidence in governments is low. People flee to its relative safety when world tensions rise; during such times, it often outperforms other investments. For example, gold prices experienced some major price movements in 2019 in response to the crisis occurring in the European Union. Its price often rises the most when confidence in governments is low.
A safe haven protects investors against a possible catastrophe. That's why many investors bought gold during the financial crisis. Gold prices continued to skyrocket in response to the eurozone crisis. Investors were also concerned about the impact of Obamacare and the Dodd-Frank Wall Street Reform Act. The 2011 debt ceiling crisis was another worrying event.
Many others sought protection against a possible U.S. economic collapse. As a result of this extreme economic uncertainty, gold prices more than doubled again. Prices went from $869.75 in 2008 to a record high of $1,895 on September 5, 2011.
In Q1 2019 economic and political uncertainty drove higher investment in Europe. Bar and coin demand rose 10% to 44t as investors became increasingly aware of the slowdown in economic growth, a heightened possibility of recession, and continued political risk. Germany, the region’s largest gold market, rose a modest 3% to 24.1t. The main drivers of growth, however, were Europe’s smaller markets. In the UK, demand rose 58% to 3.6t – equivalent to £114.8mn (US$149.5mn) – the highest quarterly value since 2012, as investors looked to protect their wealth against the potential turmoil a chaotic departure from the European Union could bring.
Gold usually does well during geopolitical turmoil and the current crisis over Korea's nuclear capability has boosted the prospects of the yellow metal. Prathamesh Mallya, Chief Analyst, Non-Agri Commodities and Currencies, Angel Broking argues, "Gold prices have been trading in $1,300-1,360 for 2018 despite the rolling geo-political uncertainties. Although the tensions have eased, $1,300 will act as a psychological support. Crises such as wars, which have a negative impact on prices of most asset classes, have a positive impact on gold prices since the demand for gold goes up as a safe haven for parking funds."
At the time of need, investments in gold can be liquidated much faster than other physical assets like real estate. Unlike many other assets there is no lock-in period in gold investments except for sovereign gold bonds. The redemption amount in case of physical gold will, however, depend on the purity of the gold, denomination and other factors including the market price.
In the case of the paper gold, the market price on the redemption date determines the redemption amount. When short of funds, one may also take loans against gold.
7. Supply Constraints
Much of the supply of gold in the market since the 1990s has come from sales of gold bullion from the vaults of global central banks. This selling by global central banks slowed greatly in 2008. At the same time, production of new gold from mines had been declining since 2000. According to BullionVault.com, annual gold-mining output fell from 2,573 metric tons in 2000 to 2,444 metric tons in 2007. It can take from five to 10 years to bring a new mine into production. As a general rule, reduction in the supply of gold increases gold prices.
Gold is both scarce and finite – another reason why it’s so highly valued. Fewer gold mines are being discovered today because exploration budgets are shrinking and mining costs are rising. The “easy” gold may have already been mined. With lower annual gold production and rising demand, existing gold could become more highly valued.
8. Increasing Demand
In previous years, increased wealth of emerging market economies boosted demand for gold. In many of these countries, gold is intertwined into the culture. India is one of the largest gold-consuming nations in the world; it has many uses there, including jewellery. As such, the Indian wedding season in October is traditionally the time of the year that sees the highest global demand for gold (though it has taken a tumble in 2012). In China, where gold bars are a traditional form of saving, the demand for gold has been steadfast.
Demand for gold has also grown among investors. Many are beginning to see commodities, particularly gold, as an investment class into which funds should be allocated. In fact, SPDR Gold Trust became one of the largest ETFs in the U.S., as well as one of the world's largest holders of gold bullion in 2008, only four years after its inception.
Gold jewellery demand is ever-rising in China and India. One of the biggest factors driving the gold price is so called Love Trade, or the seasonal gift-giving of gold jewellery prominent in China and India, the two largest bullion consumers. With rapidly growing middle classes, demand is expected to rise even further. In fact, gold jewellery ownership is so widespread in India that as of 2016, Indian households owned more gold than the top six central banks combined.
9. Direct Investment
Many investors wanted to profit from the tremendous increases in the price of gold. They bought it as a direct investment to take advantage of future price increase. Others continue to buy gold because they see it as a finite valuable substance with many industrial uses. They believe that supply constraints will eventually force up the value of this metal.
Gold is held by many governments and wealthy individuals. For the governments, much of it is legacy gold that's been kept in storage for decades. The U.S. Treasury has stored gold at Fort Knox, Kentucky, since 1937. Selling the gold now would raise anxieties and possibly disrupt markets.
10. Portfolio Diversification
Gold is one of the best portfolio diversifiers. Historically, gold has reduced losses during periods of economic distress or instability in the markets and helped to improve portfolio risk-adjusted returns. It is a mainstream asset as liquid as other financial securities and its correlation to major asset classes has been low in both expansionary and recessionary periods.
Gold should not be bought alone as an investment. Gold itself is speculative and can have high peaks and low valleys. That makes it too risky for the average individual investor. Over the long run, the value of gold does not beat inflation.
But gold is an integral part of a diversified portfolio. because its price increases in response to events that cause the value of paper investments, such as stocks and bonds, to decline. It should be included with other commodities such as oil, mining, and investments in other hard assets. Although the price of gold can be volatile in the short term, it has always maintained its value over the long term. Through the years, it has served as a hedge against inflation and the erosion of major currencies, and thus is an investment well worth considering.
The key to diversification is finding investments that are not closely correlated to one another; gold has historically had a negative correlation to stocks and other financial instruments. Recent history bears this out:
- The 1970s was great for gold, but terrible for stocks.
- The 1980s and 1990s were wonderful for stocks, but horrible for gold.
- 2008 saw stocks drop substantially as consumers migrated to gold.
Properly diversified investors combine gold with stocks and bonds in a portfolio to reduce the overall volatility and risk.
11. Central Bank
Central banks are adding to their bullion reserves. Since 2010, global central banks have been net buyers of gold as they move to diversify their reserves, with net purchases totaling 371 tons in 2017, according to the World Gold Council. Central banks buying gold to store value is a sign that investors too might want to hold some gold in their portfolio.