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Gold as an Investment

Why people buy it?


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Nicoló Patti

3 years ago | 5 min read

Among all precious metals that are available on Earth, gold is surely one that stands out, in fact, nowadays it is the most popular one from an investing point of view and is generally purchased by investors as a way to diversify risk, especially through the use of futures contracts and derivatives (contracts that derive their value from the performance of an underlying entity).

Investors that decide to invest in gold can do it in 3 different ways, by purchasing the physical asset, by purchasing a mutual fund or exchange-traded fund (ETF) that replicates the fluctuations of the gold price, or by relying on the commodities market, by trading gold options.

In general, given that buying physical gold may sometimes be costly due to additional costs that arise in the form of transaction or storage fees as well as insurance.

Moreover, on the other hand, the purchase of options which represents the right (but not the obligation) to buy or sell an asset at a specific price at a certain point in the future, is more of a speculative activity which needs a lot of research and ability to be used in a correct way.

This is why people generally tend to rely more on ETFs or other instruments that replicate the movements of the commodity and therefore gives to investors direct exposure to the metal’s price moves, combined with a sufficient level of liquidity, which gives them the opportunity to sell what they own if they need to.

History

In the past, in addition to being used for jewelry and other arts, gold has been used for a long time as a means of exchange, for efficient indirect exchange (as opposed to barter), and as a store of wealth.

As a new means of exchange, it was used in different forms of fixed weight and purity, like gold bullion coins and bars. The first known coins containing gold were struck in Asia Minor, around 600 BC, then from an earlier preference of European economies toward the use of silver, during the thirteen and fourteen centuries they re-established the minting of gold as coinage.

The Gold Standard

Then, in more recent times, after the introduction of bills and gold certificates, we have seen in the 19th Century, the introduction of a new monetary system in major economies around the world the gold standard.

The gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. It arose from the widespread acceptance of gold as a currency.

In fact, countries like the United States, at the beginning of the 19th century attempted to create a bimetallic standard, where the intention was to use gold for large denominations, and silver for smaller ones. but however, the main problem with this system was that the metals’ absolute and relative market prices changed.

Anyway, they kept the bimetallic standard even after the Civil War, where, with the coinage act of 1873, silver was demonetized, and subsequently silver started to be used solely in coins worth less than $1.

Towards the end of the 19th century, some silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the United States.

Bretton Woods

After the end of the Second World War, in 1944, the Bretton Woods System was introduced among the United States, Canada, Western Europe, Australia, and Japan.

It is considered the first example of a fully negotiated monetary order intended to govern monetary relations among independent states.

This new system consisted of an obligation for each country to adopt a monetary policy that maintained its external exchange rates within 1 percent by tying its currency to gold and to the US dollar.

Then, on 15 August 1971, the Bretton Woods System came to an end after the United States unilaterally terminated the convertibility of the US dollar to gold and by rendering the dollar a fiat currency, a currency without intrinsic value that has been established by the government as money.

The end of the convertibility of the US dollar into gold led many other fixed currencies to become free-floating.

After Bretton Woods, what influences its price now?

📷📷Gold price from 1915 to 2020 — source: Macrotrends

Nowadays, gold is traded worldwide based on the intra-day spot price which derives from over-the-counter (trading of assets done directly between two parties, without the supervision of an exchange) gold-trading markets around the world.

Given that gold is traded every day around the world, its price is mainly driven by the forces of supply and demand, but unlike most other commodities, with gold saving and disposal play larger roles in affecting its price than its consumption.

Moreover, changes in sentiment deeply affect the price of gold, which affects more its price both on the demand and on the supply side rather than what changes in annual production do.

Another main influencing factor is the behavior of central banks, in fact, they hold a relevant amount of it (19% in 2004) in the form of gold reserves, and is generally accepted that the price of gold tends to be closely related to the movements of interest rates. In fact, as interest rates rise, gold price(which earns no interest), tends to fall, and vice versa.

The close relationship between the gold price and the interest rate level means that gold prices can be closely correlated to central banks via their approach to monetary policy and especially in relation to interest rates.

Moreover, other macroeconomic variables can have an influence on the gold price, like the price of oil, the adoption of unconventional measures by the central banks like quantitative easing, currency exchange rate movements and changes in returns on equity markets.

Gold as a hedge

In addition to what has been highlighted in previous paragraphs, the use of gold is influenced worldwide by a different set of goals and purposes, which are related mainly to the goals of the buyer. One last interesting reason that I want to talk about in this article is the purchasing of gold as a hedge against financial stress.

It is common to hear, especially from famous investors, that a portion of every investment portfolio should be held in gold, this is because gold, like many other precious metals, has historically been used as a hedge against inflation, deflation or currency devaluation.

However, there are different opinions about its effectiveness as a hedge, in fact, it has not proven itself reliable as a hedging instrument, but however, in various situations, it could become useful, especially when there is uncertainty in the markets.

For other articles published by Nicolò Patti go to https://therebus.com/

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