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We’ve heard a lot about gold lately due to its strong performance in recent months amid market uncertainty. Year-to-date, gold is currently up over 10%, outperforming the S&P500.
While stock markets have rallied higher solely due to the strong outperformance of a few mega cap tech stocks, gold is signaling that it could be tough times ahead for the economy. But should investors move away from equities and into commodities?
In this article, we will explore the benefits and drawbacks of investing in gold, the ways in which we as investors can add gold to our portfolios, and finally if gold still has some upside in the future for us to benefit from.
Why do people choose to invest in gold?
Well simply put, gold has been viewed as a currency for as long as we know, even longer than the traditional fiat monetary system we follow now.
The use of gold dates back over 5,000 years ago to the ancient Egyptians, where gold signified wealth and prestige. But it’s important to identify gold’s primary use as an investment.
Where precious metals differ from other traditional investments is that these are non-productive assets. They don’t generate value for the investor throughout the time of ownership.
Where a rental property will generate the investor income through tenancies, and stocks will pay out dividends to their shareholders, a kilo of gold will only still be a kilo of gold 50 years later.
Throughout the time of owning the gold the investor hasn’t made any gains on their investment, except for the intrinsic value that the gold now holds, if it had gone up. So why do people elect to invest in gold?
A ‘Store of Value’
Like it has done for the for the past 5,000 years, gold signifies an alternative currency to our traditional monetary system. Buyers and sellers have designated a price for gold based on the simple rules of supply and demand, and where gold starts to shine is when other investments begin to dwindle.
Unlike cash which can be printed at a whim by the central bank through quantitative easing, gold is finite.
Mining gold takes time and resources, so it’s easier to maintain a level of circulation in the markets at any given time, so investors sometimes invest in gold to hedge against inflation. Although this hasn’t always proven to be particularly lucrative (especially in 2021 and 2022, falling 3.51% and 0.29% in each year respectively).
Where gold becomes a strategic asset allocation in an investor’s portfolio is to help build an ‘all weather fund’, where a portfolio can perform in any market condition. This term was coined by Ray Dalio, the founder of the largest hedge fund in the world, Bridgewater Associates.
If we look at the price chart of gold over recent history, we can see that demand for gold excels at roughly the same times other traditional investments suffer such as stocks. The highlighted areas below represent the 3 major recessions in the 21st century. The ‘dot com’ bubble, the great financial crisis, and the pandemic.
This is because gold is seen as a ‘safe haven’. Having a small percentage of a total portfolio of gold or precious metals can balance out overall losses experienced when the markets start to trend downwards.
Just looking at the price of gold during market recessions shows us this. Also, for further confirmation we can compare the correlation between the price of gold and the VIX, the index that measures the volatility of the S&P500.
An investment in gold is a hedge against volatility, which is why we saw so many flock to the precious metal when uncertainty in the markets rose. But is there any potential for gold to rise any further? Or has it hit a ceiling, and will we start to see it fall again?
A couple of factors suggesting that gold could rise even further are:
- Developed market currencies weakening pose a good environment for the value of gold. The weakening dollar in 2023 suggests the end of the Fed tightening cycle is near.
- Low treasury yields also provide a solid indication of strong performance of gold in the future. Current 10-year treasury yields across the developed markets have plunged due to the banking crisis following the collapse of Silicon Valley Bank and the acquisition of Credit Suisse by UBS. This confluence of events gives gold the ability to outperform and make a strong alternative asset for capital allocation.
But how do we invest in gold? What are the best ways to do this? Well, there are a couple of different ways, but each come with their own benefits and drawbacks. Let’s take a look at them.
How to invest in gold
The first option is to simply buy gold coins or gold bars. These track the price of gold to the day or even the hour, so they reflect fair market value, but physically owning gold can be more expensive than you think.
To store gold safely, you’ll need to store the gold in a vault at a bank or in a safety deposit box. Storage and insurance costs can easily mount up, cancelling out any gains you may see on your investment, and if the value of gold falls over time you would still incur these costs.
The other option is to store the gold in your property, but that may not give you the peace of mind you need, and owning gold shouldn’t be something that stresses you out.
Another drawback of owning physical gold is that is relatively difficult to liquidate when it comes time to sell it.
This takes time and may not suit what a lot of investors are looking for, and the second option eliminates this concern, and that is, investing in an ETC. An ETC is an Exchange Traded Commodity, these give investors exposure to commodities such as gold.
They’re traded like shares in businesses, so if you’re an active investor in the equity markets you’ll be very familiar with how this works. The price of the ETC fluctuates based on the underlying commodity it’s tracking, so in this case, gold.
Like ETFs, ETCs carry an expense ratio, where the investor incurs a percentage fee based on their capital invested. Once again, this is down to the fact that the fund manager will need to store the gold safely on behalf of the investors which incurs a cost.
It’s worth remembering that the assets under management and size of these ETCs is irrelevant, as they’re all tracking the same commodity. The price of the ETC will rise and fall in line with gold all the same.
Cons of investing in gold
As well as having many benefits, there are several drawbacks to holding gold. Firstly, gold has been known to not perform well relative to other investments over the long term.
If we track the performance of gold over 30 years compared to equity investments, the gap widens with every year that gold is held.
On top of this, if we factor in the re-investment of dividends, stocks really start to outperform gold (as per the Total Return Index). This goes back to the fact that gold is a non-productive asset and doesn’t work for you. This fact also determines its second negative.
How is gold valued?
The value of gold and precious metals in general, compared to other investments, is relatively arbitrary. It’s a number that is placed on the metal based on the supply and demand in the market.
With other investments such as stocks, we can robustly quantify their value by analysing their EBITDA, levels of debt, operating margin, and other financial metrics.
With real estate, we can compare the valuation of neighboring properties, estimated rental value and more. Since gold doesn’t cash flow for us, none of these metrics can be applied. The price is simply determined by what people are willing to pay for it at that point in time. This makes many investors uneasy and choose to steer away from it.
Once element that can determine the price of gold is its demand for jewelry. We’ve seen that during the pandemic crisis, demand for jewelry in India and China, the largest gold jewelry markets globally declined significantly. This generates a headwind for gold in an environment that it is supposed to excel in. Quite counterproductive, isn’t it?
In conclusion, gold has proven to be a useful asset for tactical outperformance when times are tough. Over an investing lifetime however, you would do well to stick with equities.
Timing every market crash to move in and out of safe havens and back into stocks is nearly impossible, and certainly not a viable investing strategy for the average retail investor, like you and I.
