Everything you need to know about gold in eight bullet points

12 Mar 2013 by Jim Fickett.

Gold is a hot topic for people with all levels of investing expertise. So it may be worth writing down the basics:

  1. Gold is money. The main reason central banks, national governments, and retail investors buy gold is because they think of it as a store of value, an alternative to paper currencies or, in more emotional terms, “REAL money”. Financial advisers and investing commentators sometimes try to discourage this behavior, pointing out that gold has relatively few industrial uses, and is not a “productive” asset, like a farm that grows food, or a house that can be rented out. But the idea of gold as real value is deeply rooted in human culture, and is not going to change.
  2. Gold more or less preserves value over the long haul. Gold is worth about the same today as it was in the mid-1500s. But there are big ups and downs in the gold price, and it is more than possible to lose half your money or double your money, so the preservation of value is only “more or less”. In other words, it does indeed make sense to buy gold as a store of value, but it matters a lot at what price you buy it.
  3. One guide to the current price is the long-run average price. Since the inflation-adjusted gold price tends to fluctuate, over time, in a fairly restricted band, it is rational to buy when the price is below the long-term average, and sell when it is above the long-term average. This is the safest course, and will usually be profitable in the long run. Currently gold is a little more than double the average inflation-adjusted price since 1969 (Historical prices of precious metals) – i.e. quite expensive.
  4. The best guide to sentiment is fear of future inflation. Since gold holds its value, more or less, and paper may not, investors often buy gold in anticipation of future inflation. Peter Bernholz, in his monumental study of inflations throughout history, showed that, quite generally, the money supply rises earlier and faster then the price of better money (including gold), which rises earlier and faster than the prices of goods and services (Bernholz, Monetary Regimes and Inflation, 4).
  5. Fear of inflation is not a quantitative guide to price. Inflation is very difficult to predict in any quantitative sense. So although there are very good reasons presently to think there is a danger of high inflation, this does not tell you what a reasonable price for gold might be. The price of gold is now more or less tracking the expansion of the US money supply but, again, this may or may not be a quantitative guide to future inflation.
  6. Gold protects against US inflation ONLY in a pre-tax account. Suppose we have terrible inflation and prices, including the price of gold, rise by a factor of ten. Before tax, you have protected value. But if the gold was held in a taxable account, the IRS will consider the increase in the gold price as profit, and you will lose a large chunk of it.
  7. Gold might be valuable in an emergency. One hears stories of refugees who manage to escape from a war zone because, unlike those around them, they can pay in gold. Such extreme conditions are hopefully unlikely to hit you, but if having a few ounces of gold gives you peace of mind, that may be worth the price.
  8. Bottom line. Gold may provide peace of mind (a commodity that is hard to price), and does provide some inflation protection (important since high inflation is a real danger). It is impossible to predict when bad inflation might strike, or how high it might go, so, although gold probably should be priced somewhat above its long term average, it is hard to say just how much one should be willing to pay. The current price is more than double the 45 year average and, if you buy at today's prices, there is a real danger that you are paying too much. Personally, I think it is perfectly reasonable to put a small fraction of one's portfolio in gold, but that there are better investments to protect against inflation.

(For a more technical analysis of trying to set a value on gold, see the post from last summer, Drivers of the gold price, and links therein.)