Investing in gold might seem glamorous, complex and only for sophisticates, but the market boils down to this: there are only three sources of supply and three broad uses. Understand these six basic components, and you could become a confident gold investor. Here's the equation for a balanced market:
The question to start with, though, is why you should be interested in gold in the first place? It is a scarce metal, but plenty of metals are scarce. It has huge historical sentimental value as a shiny yellow raw material used to make items of personal adornment, yet these days there are plenty of ways to create shiny yellow jewellery.
What has probably got you interested is the fact that it has shot up in value and you want to know if that rise is going to last. From a low of $270 an oz at the beginning of 1999, spot gold prices rose to over $1000 an oz in early 2008.
Gold's reputation as a conservative asset helps maintain the integrity of a portfolio when other investments are under pressure. A falling dollar, an inflationary surge or a dangerous war are all supposed to be good for gold. The metal is also supposed to be a good diversifier because it has such low correlations with rival investments, be they equities, bonds or other commodities.
Gold is a good store of value and protection against inflation
When people call gold a precious metal, it is not just a figure of speech. The World Gold Council estimates that, if you added together all the gold mined ever mined by humans - from the Aztecs to the Australians - it would only come to about 155,000 tonnes. To put that in perspective, crude steel production last year alone exceeded 1.1bn tonnes, or over 7,250 times the total amount of gold mined through human history.
The fact that most gold sells for the relatively frivolous purpose of making jewellery is beside the point. Because it is so rare, it is exclusive. And because it is exclusive, it is expensive and functions as a symbol of status, making it inherently desirable.
You might argue that it is merely convention that bestows a high value to gold. If fashions changed and people stopped wearing so much jewellery, gold's value might tumble. Yet its very scarcity will always provide a prop to its value. Until human nature changes and we stop coveting status and the possessions that confer it, gold will remain a desirable raw material.
Since that is the case, investors and central banks will want to hold gold because it is a liquid store of wealth that has clear advantages over holding wealth in currencies, equities or land.
Governments can erode the worth of a currency by printing more money.
Equities can lose 100 per cent of their value if companies fail or the stock markets on which they are listed cease to exist - and plenty of stock markets disappeared in the 20th century (Russia, Egypt and Germany to name but three).
Land and property, meanwhile, are only as valuable as the strength of your legal title to them. If the laws change or taxes become punitive, your property rights can go up in smoke.
Gold, however - perhaps physically held in a secure vault in Switzerland - is one way to store wealth without running the risks inherent in cash, shares or property. Admittedly, gold cannot yield an income. But supply of gold is fixed and it will always have some value. If demand rises as the world's population grows and becomes richer, the only way to balance a limited supply with rising demand is through a higher price.
The chart: 'UK: The Gold Price and the Retail Price Index' shows the gold price measured against the retail price index. Even across long periods, gold has kept up with or exceeded the rise in prices. This kind of historical data is reliable because gold has been pegged, for long stretches at a time, to specific quantities of currency.
So thanks to this reputation for holding its worth in real terms, gold should gain in popularity if people become concerned about inflation eroding the worth of their other assets.
Yet the strange thing about the current gold rally is that it has taken place against a backdrop of benign inflation. Granted, oil and commodity prices have risen dramatically, but they have not pushed inflation higher. Deflation in other areas of the world economy - due to cheap labour in China and higher productivity elsewhere - has more than compensated.
Even if the rise in gold is being fuelled by the fear of inflation, rather than its presence, you would expect that to show up in the prices of other inflation-sensitive assets, something that has not yet happened. In any case, inflation bears can buy index-linked government bonds (linkers) that are guaranteed to give a return above inflation.
However, research from David Ranson of Wainwright Economics (sponsored by the WGC), points out some problems with using linkers to neutralise inflation. These types of bonds are priced in the open market, meaning that their prices "will be affected whenever the market changes its expectations of future consumer price movements", writes Mr Ranson. The price of insurance against inflation goes up just when you need it most. Even then, linkers "only protect that portion of a portfolio invested in them. They have no ability to counteract the effect of inflation on other assets".
Mr Ronson's research goes on to argue that gold is better at protecting against inflation because it gains value especially quickly in an environment of accelerating inflation. As a result, holding just a small amount of gold can offset inflation damage to your equities or bonds portfolio.
But is there really a link? In 1999, former Federal Reserve chairman Alan Greenspan told a Congress committee that falling gold prices were "a reflection of a global reduction in the long-term inflationary outlook". If so, gold's recent rally would augur the return of inflation as a serious threat.
However, other statistical analysis has failed to find a clear link between inflation and gold. Our own economist, Chris Dillow, found that global inflation was actually bad for gold (). HSBC's head of commodities research, Alan Williamson, concludes that: "Even by including different leads and lags, we have been unable to find any evidence that there is any meaningful relationship between gold and inflation in the past 25 years."
Gold as a dollar hedge
There is a link between gold and the dollar, though. Under the Bretton Woods currency system, the US dollar was convertible to a fixed amount of gold. Central banks could switch their reserves between gold and the dollar as they required - until the system broke down in 1971 because the US economy was too weak to cope with the strong exchange rate implied by the price of gold.
Since then, gold has been a safe haven for people worried about a decline in the dollar. In times of economic exuberance, when the US economy is in overdrive, productivity is rising and the government's taxes are in surplus, people will want to hold dollars or dollar-denominated assets. The more people are happy holding dollars, the fewer people will want the reassurance of holding gold.
But if people are worried that the US government could print money to pay its bills, they will store their wealth in something other than dollars, either other currencies (which must rise if the dollar is to fall) or a commodity such as gold.
And unlike other commodities, gold's physical properties make it an excellent alternative to money. It is durable, with no depreciation costs. It is almost infinitely fungible, meaning that you can parcel it up into tiny amounts with no losses other than the costs of reshaping the metal. It trades on a deep, liquid market. It also has a high value-to-volume ratio, which makes it easier to store and transport.
If you are a UK investor, though, the question you should be asking is how much do I need to hedge my portfolio against a fall in the dollar? The answer will depend on how many FTSE 100 stocks you own. Given the high correlation of the FTSE 100 with US markets and the dependence on dollar revenues of many of our leading companies, the more UK large caps you own (either directly or through your pension scheme), the more you are at risk of a fall in the dollar.
Here again, though, the evidence is inconclusive. After a year of wobbling lower in 2004, the dollar performed strongly in 2005 - just as the gold rally was starting to gather strength. If gold has risen against the backdrop of a firmer dollar, it could be that the reverse correlation has broken down. In that case, a fall in the dollar might not be good for gold.
Gold as a good diversifier
If gold really can protect you against inflation and falls in the dollar, it would qualify as a good diversifier in a portfolio. To see the attractions, though, we need to return to the idea of a portfolio's risk-reward trade-off.
Suppose you invest all your money in a fixed-interest building society account. You expect a return of 5 per cent and there is no risk that it will be lower (or higher). That's your choice, no one can tell you it is wrong. Suppose, instead, you buy a small gold-mining stock. You expect returns of up to 200 per cent, but there is considerable risk that it will plummet. Again, you know the risks.
Now suppose we were to chart these different choices and all the ones in between. As the expected returns rose, so would the risks. That much is obvious. But the graph would not rise in a straight line because, if you assemble a well-diversified portfolio, it can offer you higher returns for the same level of risk or the same returns for a lower level of risk.
Adding gold to your portfolio is one way to diversify your portfolio and enhance returns. All that's needed is for gold to retain its value over the long term and for it to be uncorrelated with other assets. And the drivers of the gold price are so multifaceted - from the monsoon season in India to dental demand in Germany - that we should expect gold to have a low correlation with other assets.
Remember, though: this is not an argument for trading gold based on your view of where it is headed. It is an argument for holding 5 per cent or so of your portfolio in gold at all times, rebalancing occasionally - just because you do not know where anything is heading.
To illustrate the potential benefits, we looked at two sample portfolios over the past 10 years. Portfolio 1 comprises 20 per cent each of FTSE 100 stocks, FTSE 250 stocks and global equities plus 40 per cent bonds. Portfolio 2 reduces these holdings just enough to include a 5 per cent weighting in gold.
You can see the results in the chart 'Portfolios with and without gold' (below).
The more diversified portfolio outperforms the one comprising only equities and bonds, even in the first five years when gold prices were falling.
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