Much has been said about the value of investing in precious metals, and to many investors, no metal holds more “weight” than gold.
In August of 1971, President Richard Nixon set off a figurative “gold rush” when he ended the gold standard, or the ability to convert paper money directly into gold. The U.S. moved to a fiat currency system. The government now simply prints paper money--which has no literal value--and its citizens rely on it as a trusted source of payment.
But despite our paper money system, the “gold rush” has continued into the present day. Why does gold continue to be an appealing investment, decades after the U.S. gold standard? Is gold really a good investment?
Why is there so much excitement around gold?
Gold, and many other precious metals for that matter, contains certain attributes that have helped maintain its appeal. These can be broken down into three broad categories: It is tangible, limited, and reliable.
Gold is tangible
Simply put, gold is real. It’s a physical metal that you can hold in your hand. Some gold investors literally have their gold bars or coins in their home. This gives many investors and owners of gold great confidence.
As mentioned before, our current monetary system using paper money lacks intrinsic value. The U.S. dollar can be exchanged for a pack of gum because we say it carries that value. We all accept this system, but it can give gold advocates some heartburn since there's no actual value in paper currency.
Gold is limited
Not only can gold literally be held in an investor’s hand, but it is limited in quantity. We only have so much gold in our possession, and there’s only so much we will ever be able to extract from our Mother Earth. Economics 101 teaches that when you have a limited supply of something and some demand for that supply, you have something of value that can increase in value.
Gold is reliable
Gold has a strong track record. It’s been viewed as valuable for literally thousands of years. It not only has decorative appeal, like in jewelry, but it has some practical applications as well, such as in certain electronic devices. Given its history, there isn’t a strong likelihood of it suddenly becoming an untrusted source of value over night. Gold has proven to be a reliable hedge against inflation as well.
What are the historical returns of gold?
What can the historical prices of gold tell us about its practicality as a good investment? Let’s look at the data.
An article by financial author Ben Carlson discussed the historical returns of gold. Here’s a chart from Ben’s article.
Some of these returns are mind-blowing--for better and for worse. You can see that in the 1970’s gold returned an average of over 30% per year! This was far better than how the stock and bond market performed.
But following the “gold rush” of the 70’s, gold did quite poorly over the next two decades, averaging negative annual returns in the 80’s and 90’s. The 2000’s were once again very strong for gold, and so far during the 2010’s gold has been mostly flat.
What are the problems with gold?
Gold critics tend to lean on two arguments about why gold is a poor investment. Ironically, the first argument is the same one used by gold advocates against the use of paper money.
Gold’s intrinsic value is uncertain
Even though gold tends to be a highly sought-after precious metal, the fact remains that gold does not have clear intrinsic value. Like paper money, gold has value because we say it does. This illustration by financial advisor and consultant Michael Kitces is helpful.
“What makes gold a good deal at $500/ounce or $1,000/ounce, fairly valued at $1,300/ounce, still a reasonable opportunity at $2,000/ounce, but “too expensive” at $5,000/ounce? Nothing, but the belief of the markets that those are or are not reasonable prices.”
This is one of the main challenges with gold, and one of the reasons why we have seen such wild swings in its price over time.
Gold does not generate cash flow
What does it take for an asset--whether gold, cash, real estate, or stocks--to have intrinsic value? It must have the ability to produce reliable cash flow. When an asset has the ability to produce cash, it can be given a more reliable value.
For instance, if you were considering buying a rental property as an investment, how would you know whether to pay $200,000 or $2,000,000 for it? A huge deciding factor would be to look at the existing or anticipated cash flows the asset can produce. These cash flows (without getting too geeky here) are used to calculate a “net present value” of the actual rental property.
There are obviously other factors that go into determining the value of the property, but knowing the expected cash flows is crucial. Without them, it’s mostly guesswork. Gold produces no cash flow. As Kitces points out in his article, your gold doesn't produce more gold.
The Gold Rollercoaster
The fact that gold does not have similar intrinsic value of other income producing assets helps explain why the price of gold can be so volatile. The chart below illustrates the incredible rollercoaster ride that gold has been on. Yes, gold has had some incredible returns...but it’s had some big dips too. This volatility must be understood by gold investors. There’s no reason it won’t continue.
As with any asset, the importance of diversification is good to bring up at this point. Gold and other precious metals can certainly have a place in your portfolio, but those should be balanced with a variety of other assets as well--like stocks, bonds, real estate, or cash.
I hope this review of gold investing has been helpful to you. I don’t consider myself “anti” or “pro” gold investing. Gold, like other assets, has its virtues and vices. Gold can have a rightful place in many investment portfolios, but those portfolios should contain a variety of other assets as well. That’s the only way to “temper” the ups and downs that gold tends to bring.