Why Hold Gold

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There are at least three classic reasons for holding gold as part of a portfolio:  1) As protection from a weakening dollar 2) As an inflation hedge 3) For diversification as it is uncorrelated to other investments. Although in many ways these are different sides of the same (gold) coin, we hold gold for all three reasons.

Gold can be thought of as portfolio insurance, something that will show its worth in times of exceptional events. If there are real difficulties in the global economy, if there is sudden and unexpected inflation, it is an asset that will hold up. Gold has been a store of value since human economic activity began, and this leads one to believe that when things get sticky again, people will turn to gold (as well as silver, probably, maybe platinum and several other assets).

As well as a falling dollar and the possibility of inflation, there are a few issues at present that cause us to think having a bit of gold is not a bad idea.

Firstly, let’s consider the banking system. Interbank rates are high at the moment, partly because banks need to hoard capital to maintain their capital adequacy ratios, but also partly due to their lack of faith in each other. With banks not trusting each other, and contagious events such as the run on Northern Rock, one could hardly blame the general public if they were to lose faith in banks as well. If people are worried about the stability of banks, might they also be concerned about electronic money as a whole. After all electronic money could not exist without the banks.

If belief in the banking system and money more generally is questioned, where do you turn for safety? When the banking system is under pressure, one can be sure that the economy is also struggling, and when the economy is struggling, many assets become less attractive; stocks certainly, but also luxury assets that have boomed in the good times such as art and wine. Even old reliable property might not be that attractive, as, at current prices, a lot of property is not earning an income yield that justifies the price.

Secondly, let’s think about currencies. The central bank’s policies of continuously cutting rates and increasing money supply at any sign of adversity will at some point undermine the value of currencies. That’s only simple supply and demand.

Over the course of history it is rare for fiat (i.e. paper-based) currencies to float freely for long periods of time. Traditionally, people have lost faith in currencies as the policy makers have devalued it for political reasons. Emperors, kings, and democratic governments have all eventually given in to the temptation to scrape a little off the value of the currency, by printing more paper money, re-issuing currency with less precious metal in it, or other means. Let’s hope the last ten years of very fast money supply growth isn’t just another example of taking the easy but oh-so-dangerous option. It might work for a time, but eventually the general population loses confidence in the currency. Confidence will survive a battering, but once lost, it is very difficult to recover.

Although portfolio insurance is the key reason we hold gold, it’s not the only one. We also think that demand from investors can hold up the price. In the 1970’s it was not unusual to have a private banker suggest holding 5-10% of one’s assets in gold. We feel there is a good chance that, as pressure to diversify increases, favour will swing in that direction again. By the way, the World Gold Council reported recently that investment demand has increased 45% per annum since 2003.

If you’re a conspiracy theorist, you have tinned beans, a bunker miles from population centres, a lot of water, petrol and shotgun shells, and your entire wealth in gold bullion. We think that’s going a bit far, but having a small amount of the portfolio invested in gold (as insurance to tide us over in case of bad times, and as a bedrock of value with thousands of years of history behind it) might just turn out to be a sound strategy.

A few interesting facts about gold:

  • One reason why gold is such a useful store of value is that it is independent of any institution or individual, i.e. is no one else’s liability. A bond or a banker’s note is a liability of the corporation or bank, and even a unit of currency is a liability of the central bank/central government. This characteristic is true, of course, of many assets, but gold is one of the few which straddles the roles of physical and financial asset.
  • It is interesting to note that the two thousand tonnes of gold mined each year compares to an estimated 158 thousand tonnes mined in history (according to the World Gold Council).
  • 52% of this in jewellery, 12% is industrial, 16% is private holdings, and 18% is official holdings.
  • Current underground reserves are estimated at 22 thousand tonnes (but that tends to stay steady as reserves are replaced as they are used up)
  • Supply and demand: Demand for jewellery is 2,510 tonnes per year, investment is 590 tonnes per year, and industrial is 460 tonnes per year. This is supplied by mines producing 2,130 tonnes, official sales of 370 tonnes and recycled gold of 970 tonnes (source: World Gold Council).
  • Although gold has often backed currencies in one form or other, silver and gold have also at times been dual foundations for currencies, a system called bimetallism. The cheaper metal would be the dominant form of currency, as the more expensive metal would be hoarded. This did allow some flexibility to a notoriously rigid system.

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