Gold as an Investment
Why invest in gold? Excerpted
from A Guide to Investing in Gold by the World Gold
Council
The reasons for investing in gold have remained much the
same over history:
Long-term
Store of Value
Gold has acted as a reliable "store of value"
because it fulfills the functions of money:
- It is portable and divisible. Its weight is a good measurement
of a unit of value.
- It is indestructible, relatively scarce, and cannot
be "manufactured".
- It is easily recognizable and acceptable as a form of
payment.
Through both hard times and times of plenty, gold endures.
Market cycles are permanent facts of life but gold has maintained
its long-term value. In contrast, most currencies (including
the U.S. dollar) and industrial commodities have generally
declined. This is why gold is so often purchased as a hedge
against inflation and currency fluctuations. And why so
many investors around the world see gold as the "ultimate
asset" - an important and secure part of their investment
portfolio.
In other words, the value of gold - what it can buy in
real goods and services - has remained remarkably stable
over time. For example, a man's suit in sixteenth century
England at the time of King Henry VIII cost the equivalent
of one ounce of gold, roughly the same as a suit would cost
today.
Asset of Last
Resort
Gold is known as the "asset of last resort".
Throughout history, national currencies have come and gone
but gold has remained remarkably stable. Gold is an asset
which does not depend upon any government's or corporation's
promise to repay. It is not directly affected by the economic
policies of any individual country and it cannot be repudiated
or frozen as in the case of paper assets. For these reasons,
one quarter of all the gold in existence is held by governments,
central banks and other official institutions as part of
their international monetary reserves. There is nothing
to suggest that gold's reliability as a long-term store
of value will change in the future, despite there being
from time to time a more attractive "money" safe
haven such as the U.S. dollar, for example, or the Swiss
Franc.
Highly Liquid
Gold is among the most liquid of the world's assets. It
can be readily sold 24-hours a day in one or more markets
around the world. This cannot be said of most investments,
including stocks of the world's largest corporations. In
addition, the trading spreads on bullion are comparable
to those on stocks and bonds (which are considered to be
liquid assets). Finally, it takes about the same amount
of time to execute a trade in gold as it does for stocks
and bonds.
Asset Diversifier
Whether your investment approach is conservative or aggressive,
gold can play a vital role in diversifying your portfolio.
For this reason, many experts urge investors to keep a portion
of their total assets in gold. Since most portfolios are
invested primarily in traditional financial assets such
as stocks and bonds, adding gold to a portfolio introduces
an entirely different asset. The purpose of diversification
is to protect the total portfolio against fluctuations in
the value of any one asset class. Gold does exactly that.
Gold's ability to serve as a diversifier is due to its
low-to-negative correlation with stocks and bonds. The economic
forces that determine the price of gold are different from,
and in many cases opposed to, the forces which determine
the prices of most financial assets. For example, the price
of a stock depends on the earnings and growth potential
of the company it represents. Likewise, the price of a bond
depends on its safety, its yield, and the yields of competing
fixed income investments. The price of gold, however depends
on different factors including the supply and demand for
gold, the status of the U.S. dollar, the state of inflation
and interest rates. While the effect of these factors on
the gold price are somewhat complex, the important point
to remember is that they cause the price of gold to move
independently of the prices of other assets in a portfolio.
Gold is the only asset that is negatively correlated with
other asset classes as demonstrated in the chart above.
Therefore, its price generally moves in the opposite direction
from other asset classes such as U.S. stocks, Treasury bills,
and bonds.
Due to its negative correlation to other asset classes,
gold can reduce portfolio volatility or risk. the chart
above illustrates how a negatively-correlated asset (like
gold) can lower portfolio volatility or risk. In this example,
a new asset is added to a portfolio with a risk level of
10% (as measured by standard deviation) to amount for 10%
of its total value.
The more negative the correlation between the new asset
and the pre-existing portfolio, the lower the overall level
of volatility will be for the new portfolio. For example,
if the new asset is perfectly correlated with the pre-existing
portfolio (that is, the correlation is 100), then adding
any amount of the new asset will not change the level of
portfolio risk. However, if the new asset has a correlation
of less than 100, (say 50), it reduces portfolio risk slightly
to a level of 9.6%. If the new asset has a correlation of
0, then the portfolio's risk is reduced modestly to a level
of 9.2%. Finally, if the correlation of the new asset has
a correlation of -50 (similar to gold's correlation with
U.S. equities), then portfolio risk is reduced significantly,
to a level of 8.8%.
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