All that is Gold Does not Glitter

Over the past few years, gold has received a great deal of attention from both new and seasoned players in the financial markets. Jargon such as ‘inflation hedge’, ‘store of value’ and ‘fiat currency’ are constantly thrown around to fuel the hype and controversy surrounding this age-old commodity. Sure, all of this makes for an interesting academic discussion, but what does it mean for a university student who is just trying to get an answer to one seemingly simple question – “If I put money into gold, will I make money?

After doing some research, I was left somewhat disappointed in the answer I got to the aforementioned question – “It depends…” and on more things than I first realised. Firstly, am I hoping to make money trading gold or investing in gold; that is, am I planning to buy/sell some gold and close the position in a few minutes/days/weeks, or am I planning to hold onto gold for decades and maybe make some money by selling it when I’m satisfied its productive faculties have been exhausted? In this question is nested the more fundamental question of why are you trying to buy gold in the first place? Perhaps the most common answer to this is that it is an “inflation hedge”. What does this mean?

Gold is commonly considered an “inflation hedge” because there is a fixed supply of gold in the world. If there is only so much gold in the world, it will always be precious and valuable, hence why it is also referred to as a ‘store of value’. Now, let’s talk about ‘fiat currencies’. Fiat currencies are the Australian Dollar, the Japanese Yen, the US Dollar etc. They are issued by the government and only have value because the government says so. If the government says the Australian Dollar is worth nothing, then all you have is a piece of metal or paper because the currency is not backed by a commodity such as gold. A $10 note would have no more use than toilet paper. The hyperinflation in 1920s Weimar Germany is a good example of this phenomenon. On the other hand, the government cannot manipulate the value of gold by printing or making more of it like they can with their local fiat currency. Thus, when inflation gets rough and the government cannot be trusted to keep the value of their currency on the ground, people look to gold to maintain the value of their money.

1920s hyperinflation in the Weimar Republic

Naturally, the next question to ask is whether buying gold as an inflation hedge has worked historically. The answer to this depends on the aforementioned important factor as to whether you are trading or investing in gold. In the 2012 research paper, ‘The Golden Dilemma’, by Claude B. Erb and Campbell R. Harvey, it was found that gold was a decent long-term inflation hedge but the long-run may be a time horizon that goes beyond the investor’s life span. In other words, for investing in gold to be worth it, you have to be prepared for the possibility that you hold onto it till Kingdom Come. What about trading gold? The same paper found that gold returns from 1975 to 2012 indicate that gold does not serve as a good inflation hedge in the short-term either due to the volatility of its real price. Gold doesn’t sound too glamorous anymore, does it?

Nevertheless, there are quite a few arguments that immediately come to mind for putting money into gold. The first one is that you can still profitably trade gold if you buy and sell it at the right time. This is true of any instrument and requires a decent amount of technical expertise to consistently get right. Sure, you may profit from a friend’s tip this time, but that means you would rely on that friend’s tip (or another random helper) for future decisions on whether to put money into gold. This is more precarious than it may sound because not only would you need to buy/sell it at about the same time and price as them, but you would also have to close the position at the right time and price – the latter is often the more difficult decision. Another argument that can be made is that if taking a position in gold isn’t so glamorous, why are there so many big names (e.g. Ray Dalio, Robert Kiyosaki, Jim Rickards) who do just that? The answer to this question lies in the answer to the first question. Instead of a friend giving you advice, it’s a celebrity financial genius who isn’t going to tap you on the shoulder every time they change their position.

Even if the aforementioned challenges do not bother you, the question “If I put money into gold, will I make money?” still contains yet another ambiguity. How much of an investment in gold are we talking about? Are we talking about putting 100% of our net worth in gold? 40%? 2%? With this line of questioning brings up yet another argument made in favour of gold – portfolio diversification. Gold does indeed have a low correlation to many asset classes, as shown in the table below. A small 0-10% allocation in a portfolio may indeed be worth it. The impact of opening or closing a position incorrectly would have less of an impact on your portfolio the smaller your position in it. However, the issue with this is that the typical university student may not be managing such a large amount of money so as to reap the benefits of diversifying via gold. A university student with only few thousand dollars may end up having their relatively small profits in gold-trading eaten away by commissions and other fees. Alternatively, buying and sitting on stock and bond ETFs mean that frequently closing positions and incurring the associated fees won’t be a dragging factor.

Correlation between assets classes

It should also be noted that while the gold price chart seems to indicate quite a spectacular run for gold over the past 50 years, there is an opportunity cost to sitting and holding onto a physical gold bullion for so long. A criticism that is often made of gold is that it is not a cashflow producing asset and doesn’t grow. A gold bar in a safe is not going to magically give birth to a little gold nugget or cash dividend. Not getting that dividend means you miss out on the opportunity to put that put money into something else – a problem not as prevalent for equities. To this, it may be answered that some gold ETFs do in fact pay dividends. However, that is because they are comprised of many gold stocks. Owning gold mining stocks is not the same as owning physical gold because the former involves buying into a business and the unique characteristics/risks that go with it (e.g. quality of management). It is for this reason that Warren Buffet’s 2020 investment in Barrick Gold Corporation should not be viewed as him buying into the gold commodity per se.

Gold price graph

References:

https://www.nerdwallet.com/article/investing/stock-trading-vs-investing

https://www.youtube.com/watch?v=ulgqlQWlPbo

https://www.investopedia.com/terms/f/fiatmoney.asp

https://alphahistory.com/weimarrepublic/1923-hyperinflation/

https://www.nber.org/system/files/working_papers/w18706/w18706.pdf

https://www.youtube.com/watch?v=wK6mUl3YMwU

https://www.youtube.com/watch?v=E5VNAEmmBQM

https://medium.com/cv-vc/why-its-time-to-diversify-your-portfolio-with-bitcoin-951f03db833

https://stockhead.com.au/resources/warren-buffetts-barrick-gold-investment-tipped-to-inspire-investors/

https://www.youtube.com/watch?v=8fIUGO_-nSQ

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