What makes gold so valuable?
Since the dawn of human civilization, gold has been as a symbol of wealth and prosperity in ancient kingdoms ranging from the Pharaohs of Egypt, Chinese dynasties, or the Roman Empire.
Gold’s intrinsic value derives from its
- Limited Supply: The supply of gold is limited when compared to other resources. This relative scarcity make gold inherently valuable. If all the gold in the entire world could be accumulated, it would fit into a 28m cube!
- Aesthetic and Industrial Value: Gold is one of the most lustrous (shiny) metals with a unique and beautiful color. Whilst silver can be just as lustrous, it tarnishes much more quickly. No other metal quite has the same beautiful hue as gold. Not surprisingly, it has been used in jewelry and other beautiful artefacts, and has universally accepted value.
Gold’s inherently limited supply, combined with universal demand has made gold a form of money for many centuries. Ancient civilizations minted coins from gold. As economies modernized, governments issued paper-based currencies, which were pegged and convertible in a fixed ratio to certain quantity of gold. This system was known as the gold standard.
The history of money is intertwined with the history of gold. For thousands of years, gold and money have been recognized as equivalent. It is only in the last fifty years that our concept of money has been decoupled from gold following two major events:
- Bretton Woods System: After World War II, the World’s superpowers decided to fix their currencies to the US Dollar. In turn, the US fixed the price of the US dollar at $38 per ounce of gold.
- Nixon’s Abolition of the gold standard: In 1971, Richard Nixon temporarily halted the convertibility of the US Dollar into gold. Although this was initially stated as a temporary measure, from 1971, the US government does not need to back its currency with gold reserves.
7 Reasons that make gold a great investment
Here are seven factors that make gold a great investment
- Inflation protection: Gold is an excellent hedge against inflation. Since 1971 when the gold standard was abandoned, the US government has been able to print unlimited quantities of money. More money chasing the same quantity of goods and services causes their prices to rise (inflation). However, since gold is naturally scarce, it has been able to retain its value.
- ‘Safe Haven’ asset: Gold is a safe haven asset. Whenever there is geopolitical uncertainty (war, natural disaster, coups/ change of government), investors convert assets into gold – which is universally valued around the world. This is particularly true during debt crises, such as the Global Financial Crisis. At this time, many US and corporate banks started to face bankruptcy, which in turn caused banks and corporations around the world to face similar issues. This led stock prices to fall by nearly 50%.
When financial turbulence occurs in the market, many investors, businesses, banks and even the public pull their money out of the stock market and buy gold, this results in increased demand and price of gold.
- Hedge against Rupiah Depreciation: As gold is essentially priced in USD, investing in gold can provide an effective hedge against depreciation against the USD. Over the last 20 years, gold has appreciated 750% against the IDR:
Note that Gold prices soared more than 500% during the 1998 Financial Crisis from a level of IDR 750,000/oz to IDR 4,800,000/oz.
- Hedge against USD depreciation: whilst the USD is acknowledged as the world’s reserve currency (80% of all global trade is conducted in USD), gold acts as an alternative currency. Thus when the USD weakens, investors flock to gold.
- Portfolio Diversification. Gold tends to have a low correlation to other financial asset such as stocks. Thus, when stocks go down, gold tends to go up. This has occurred in the GFC in 2008 and Covid pandemic in 2021. This low, and sometimes negative correlation, allows investors to reduce risk and hence makes gold an excellent diversifier in any portfolio.
- Increasingly Limited Supply. Gold has a strictly limited supply, and due to increasing environmental concerns, it is becoming increasingly harder to open new gold mines. The supply of gold is expected to increase <1% p.a.
- Increased Demand from Emerging Markets. As economies with massive populations such as China, India and Indonesia start to develop, so too does their demand for gold in the form of jewelry and investment.
4 Key risks of investing in gold
Whilst gold has generally been an excellent long-term investment, in the short term, gold – like any asset – can decrease in price. Gold prices are particularly sensitive to the following factors
Interest Rates: Whenever there is an increase in interest rates, gold prices tend to fall. Since gold produces no yield, high interest rates increase the opportunity cost of holding gold. An investor, with say, $1000 could choose to buy gold (which produces no income) or a bond (which produces interest). If interest rates rise, then all else equal, an investor will tend to choose the asset with the higher yield.
Inflation: When inflation increases unexpectedly, the price of real assets – including gold – will also rise to keep pace with inflation. Conversely, as inflation or expectations of inflation fall, so too will the price of gold.
These two factors are linked:
Real interest rates = Nominal Interest Rates – Inflation.
Hence gold prices generally increase when real rates are low, i.e. when (1) The Federal funds rate are decreasing (2) Supply and Demand in Bond market cause longer term rates to decrease (3) Inflation is high.
During COVID, as financial markets collapsed and the Fed printed enormous quantities of money, the price of gold soared 25%. In Q2 of 2021, as fears of inflations started to subside, the price of gold also fell
Exchange rates: As the global price of gold is set in USD, whenever there is a decrease in the Rupiah, gold prices in rupiah will rise
Speculation: Many investors around the world carefully monitor interest rates, inflation and exchange rates to determine what will happen to the price of gold. Thus a movement in any one of these factors can trigger a movement in the gold prices. As capital now flows very quickly, this can create momentum and even larger swings in gold prices.