A History of Holding Its ValueUnlike 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.
Weakness of the U.S. DollarAlthough 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.
InflationGold has historically been an excellent hedge against inflation, because its price tends to rise when the cost of living increases. Since World War II, the five years in which U.S. inflation was at its highest were 1946, 1974, 1975, 1979 and 1980 (as of 2012). During those five years, the average real return on the Dow Jones Industrial Average was -12.33%, compared to 130.4% for gold.
DeflationDeflation, a period in which prices decrease, business activity slows and the economy is burdened by excessive debt, has not been seen globally since the Great Depression of the 1930s. During that time, the relative purchasing power of gold soared while other prices dropped sharply.
Supply ConstraintsMuch 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 (however, according to Goldsheetlinks.com, gold saw a rebound in production with output hitting nearly 2,700 metric tons in 2011.) 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.
Increasing DemandIn 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 jewelry. 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.
Portfolio DiversificationThe 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.
The Bottom LineGold should be an important part of a diversified investment portfolio because its price increases in response to events that cause the value of paper investments, such as stocks and bonds, to decline. 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.
