A History of 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 preserve and pass on their wealth from one generation to the next.


Weakness of the U.S. Dollar

The U.S. dollar is one of the world's most important reserve currencies. When the dollar devalues, gold moves inversely as it did in 2008, reaching the $1000-an-ounce milestone in early 2008 and nearly doubling between 2008 and 2012, hitting above the $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.


Inflation

Gold has historically been an excellent hedge against inflation, because it 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. During those five years, the average real return on the Dow Jones Industrial Average was 12.33%, compared to 130.4% for gold.


Deflation

Deflation, 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 1930's. During that time, the relative purchasing power of gold soared while other prices dropped sharply.


Geopolitical Uncertainty

Gold is often called the "Crisis Commodity," because people flee to saftey when world tensions rise. During such times, it often outperforms other investments.This was seen when gold prices experienced some major price movements in response to the crisis occurring in the European Union. The gold price often rises the most when confidence in governments is low.


Supply Constraints

Much of the supply of gold in the market since the 1990's has come from sales of gold bullion from the vaults of global central banks. This however has changed as selling by global central banks has slowed dramatically whilst production of new gold from mines has been on the decline since 2000. Annual gold-mining output fell from 2,573 metric tons in 2000 to 2,444 metric tons in 2007. It can take from 5 to 10 years to bring a new mine into production. As per laws of supply and demand, reduction in the supply of gold increases gold prices.


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. 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.


Portfolio Diversification

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 not great for stocks
  • The 1980s and 1990s were wonderful for stocks, but not great for gold
  • In 2008 stocks dropped substantially as consumers migrated to gold

Diversified investors combine gold with stocks and bonds in a portfolio to reduce the overall volatility and risk.


The Bottom Line

Gold 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 out the years, gold has served as a hedge against inflation and the erosion of major currencies, and thus is an investment well worth considering.