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For millennia, gold has performed a major function within human society. Throughout history, from the first civilizations to contemporary times, gold has been used as a store of wealth. From its first discovery, it was used to create valuable objects, later it was used to barter for other goods and land.
Still, nowadays gold is mostly used for jewelry, 50% of global demand for the shiny yellow metal comes from jewelry. Population growth, increased wealth, and industrial use are only increasing. All 3 factors contribute to the demand for gold.
We are going to look at why gold is so valuable, and why it might or might not be a good fit for your portfolio.
What makes gold valuable?
Gold is valuable principally due to three factors from its early years to the present day: scarcity, durability, and malleability. Other precious metals have been found with similar characteristics, although they fall short in subtle but important ways. However, they have not passed the test of time, neither are they considered in the collective mind of society the metal of excellence.
The amount of gold in the world is limited, and this helps the precious metal keep its value. Estimates of mined gold suggest around 201,296 tonnes of the yellow metal have been mined so far. If you were to put all those tonnes of gold together, they would form a cube of approximately 68 ft. Which would fit comfortably in the center of a football field.
So gold is scarce, but not too scarce. Rhodium is also scarce, but it is estimated world production is only 30 tonnes of the silvery metal. Perhaps too scarce, and it was only discovered in 1803. Gold yearly production is also limited. World production of gold for 2020 was 3,247 tonnes or around 2% of the current total, which means the scarcity of gold will continue.
Gold is one of the few materials on our planet that can literally withstand the test of time. Archaeologists have uncovered all sorts of ancient artifacts throughout history. We can all think of the first gold coins used thousands of years ago.
However, gold jewelry and artifacts have been found that go back even further in time. In 1972 jewelry discovered in Vana, Bulgaria was dated back to around 4,400 B.C. More recently, a gold artifact discovered in a pre-historic settlement in Bulgaria was dated back to 4,500-4,600 B.C.
The archaeologists who made this discovery claim it is possibly the world’s most ancient piece of manufactured gold. The discovery certainly shows how long gold can keep its characteristics, despite the adverse effects of time.
The two features of gold mentioned above certainly have a big weight in making gold so valuable. However, what really makes gold stand out is that added to these two qualities it also has a third, malleability.
Gold is the most malleable metal of all. It can be beaten and stretched beyond all limits. Just 1 ounce of gold is enough to beat it into a continuous sheet of around 100 square feet. Or, with the same ounce of gold you could stretch it into a wire so thin it would cover a 50-mile straight line.
Gold as an Investment
Now we’ve answered the question, why is gold valuable? Let’s look at whether investing in gold is right for you. We are going to analyze gold’s performance, and its characteristics when held in a portfolio before we draw some conclusions.
To analyze the performance of pretty much any asset you need to compare it to a benchmark. A reference to assess how well the asset is doing. For gold, a common benchmark is a broad stock market index. In this case, I’m using the Dow Jones Industrial Average (DJIA) as it is well known and includes some of America’s biggest corporations.
The chart above shows the performance of gold and the DJIA from 1971. I chose 1971 because it is the year Nixon ended the convertibility of gold. From that year the price of gold was allowed to float according to the forces of supply and demand.
As we can see, gold has outperformed the broad stock market index by 225%, during the 30-year period. In fact, apart from the period between the late 1990s and mid-2000s, gold has pretty much outperformed consistently.
Before we come to any final conclusions, it’s important to remember that stocks pay dividends. If you reinvest this income stream as you receive them, you earn compound interest. Adding this income stream to your investment greatly increases your total return.
An exact estimate of how much your total returns might be is not possible. However, an educated guess based on calculations of dividends reinvested monthly gives the total return for the DJIA at 22,398% for the same period.
Gold has always been known for its capability of withstanding the erosive effects of inflation. When the dollar loses its value through inflation, gold holders will want more of those dollars to sell their gold. Since gold is a store of value, it does just that. If I am to exchange my gold for something that has less worth, I will want more of it to compensate.
Source of Data: MacroTrends
The chart above shows the value of gold through two of the most recent inflationary periods. From the mid-70s to early 80s, and from the late-80s to 1990. As we can see, gold maintained its value over both inflationary periods.
Why is portfolio diversification important? Well, mainly for 2 reasons, it reduces your overall risk when compared to the risk of the stock market. And it creates returns that are not correlated in a big way to the returns of stocks.
These two aspects act as a way to protect your portfolio from downside risk. When the stock market crashes, or experiences high volatility, you are probably going to wish you hadn’t invested everything in stocks. You don’t want to see the S&P 500 drop 30, 40, or more percentage points if that is where all your money is.
So, portfolio diversification helps protect your portfolio. Some investors like to think of it as insurance. Although there is no insurance when it comes to investing. I guess the term comes from the cost of giving up some growth, to see your portfolio suffer less in times of stress.
The value of holding gold in a portfolio is best seen in times of market selloffs. We already know that holding a diversified portfolio reduces your returns over time. But investing is not all about gaining exposure to the highest returns. We all have a trade-off with risk, we want less risk as well as decent returns.
Market Stress & Diversified Performance
Below is a graph of the performance of two hypothetical portfolios. One is invested in the traditional 60-40 split between stocks and bonds. The other portfolio also has 20% of gold, the stock bond split is 50-30.
The graph shows the performance of these two portfolios and that of the S&P 500 during the 2007 recession. The period goes from November 2007, just before the onset of the bear market. And runs through to March 2009 which was the bottom of the selloff.
As we can see the general stock market, represented by the Vanguard 500 Index Investor fund, hits a sharp nosedive as the year 2008 ends. While the two portfolios manage to soften the losses. The portfolio with the smallest decline is the one that included gold.
Let’s have a look at some more specific numbers in the table below, that are not clearly visible on the chart. The worst performance over this period was for the S&P 500. The fund had a maximum drawdown of nearly 51%.
The stock and bond portfolio had a much better performance, losing 23.44% over the crisis. However, the portfolio that had a 20% allocation to gold did even better, losing 18.18%.
This table looks at the mini-crash of 2020 which was sparked by fears of a global pandemic extending over an indefinite period. The worst performing portfolio was again the Vanguard S&P 500. The fund had a max drawdown of 19.59%, while the 60/40 fund had a loss of 9.78%, and the portfolio with gold did a little better dropping 8.55%.
If you look at any other crisis period over the past 30 years, you’ll see the same pattern. As gold’s price has little to no correlation with stocks, gold tends to have positive returns even when the stock market is falling.
How to Invest in Gold
You can invest in gold in a variety of ways starting with buying bullion to store at home. Or you can buy bullion to hold in your Self-Directed IRA. Bullion includes all bars and coins of the highest purity, while coins must not have any numismatic value for you to include them in an IRA.
Another way of investing in gold is through a fund. Various asset managers operate gold and precious metals funds. You could buy a fund that invests in gold stock, usually mining companies. In my opinion, this type of fund is not a pure gold play. There are other risks associated, as you are investing in a company, and that carries various corporate risks.
One of the best ways is to invest in an ETF. These funds are listed on exchanges and many of them have the kind of liquidity associated with the stock market. High liquidity means you can easily and quickly increase and cut back your exposure to gold.
With a fund, you won’t have to worry about storage costs, insurance, or transportation. All that is done for you. The largest ETF on the market is the SPDR Gold Shares (GLD:NYSEArca). The fund manages over $60 billion in assets, and the average daily trading volume is over 8.1 million.
The factors that make gold so valuable have been around for so long that they don’t look like they will disappear anytime soon. So, now we understand why gold will keep its value, we need to decide if we should include it in our portfolio.
Deciding whether gold is a good fit for your portfolio comes down to the importance you give one factor. That factor is income streams. Gold, unlike stocks and bonds, does not generate any income streams.
With gold, your returns are simply in the appreciation of price as the years go by. So, it depends on how important an income from your investment is for you. It might be so important that it outweighs the possible benefits of holding gold.
Before you make a final choice, you should always ask yourself these 3 questions about your portfolio. How will my portfolio fare in a crisis? Am I short of liquidity? And what are the return sources of my portfolio?
The bottom line, diversifying by adding gold is a good option. However, diversifying with more alternative assets is even better. For example, you could also add real estate. For more information on how to add this asset to your portfolio, check out our real estate investing guide.