Dear Happy Investor, In this article, Jorgo takes us through the 3 main advantages and disadvantages of investing in gold. Does investing provide us with positive returns? For example, what is the effect of the US dollar on the gold price? The central question is: why invest in gold? (or why not invest in gold?). We also provide an outlook on the gold price.
Let money work for you!
Gold is a commodity, just like oil for example, and is mainly mined by gold mining companies. Specifically, gold is a precious metal such as silver. Gold is an alternative asset classes and, thus, has other risk-return characteristics than equity or bonds which is beneficial for diversification. Therefore, gold can be an attractive addition to your investment portfolio by means of exposing your wealth to other risks. On financial markets, the gold price is typically expressed in US dollars ($) per troy ounce (1 troy ounce = 31.1 gram).
There are 3 ways to get exposure to gold, which you can do individually or through funds:
- Physical gold – You directly invest, either yourself or through a fund, in physical gold that is kept safely in banks. Note that you do not receive gold yourself.
- Gold mining companies – You invest in a precious metal mining company. Indirectly, the gold price influences (heavily) the value of the mining company because the mining companies deliver the gold to the market and, thereby, determine the supply of gold.
- Gold futures – Large professional institutional investors, such as pension funds, use exclusively gold future investments.
- Gold ETFs (GETF) – There are funds like a gold mining company ETF in which you can quickly and easily purchase multiple gold mining companies at the same time.
So there are multiple ways to invest in gold. But why invest in gold? Besides applying diversification, are there any other reasons for why invest in gold?
Over the last 5 years, gold has seen a steady increase in prices from $1300 to $1800, which explains the popularity of gold investments for long-term investors. However, over the past year (July 2020 – July 2021) gold has a negative 1-year trend of -3.97%, which is visible in Figure 1 below.
For long-term investors, negative short-term fluctuations are less relevant. So, the question is: is this negative trend a short-term temporary decrease, or should we be worried about long-term consequences?
Figure 1: Gold price in USD ($) over the last year. Source: Financial Times, COMEX Gold
To answer this question, and the answer on why to invest in gold, we should distinguish between short-term temporary shocks and long-term fundamental shocks to the gold price. There are 3 main factors that influence the future gold price heavily.
It is important to understand these effects if you want to know why invest in gold.
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- Effect of US dollar on gold
By construction, the gold price is linked to the US dollar. So, fluctuations in the US dollar influence the gold price directly. Specifically, the correlation between the US dollar and the gold price is strongly negative. If the US dollar rises (drops), then the gold price drops (rises). Over the past 20 years the correlation was -42%, and over the past 45 years the correlation was -40%. Hence, the relation between the US dollar and the gold price is incredibly strong, and the US dollar is a good predictor for the gold price. For this reason, gold is sometimes called an ‘anti-dollar’ investment.
In short, one reason for why investing in gold can be because you understand this relationship well and can use it to your advantage.
- Effect of the real interest rate on gold
What matters for the gold price is the real interest rate. The real interest rate is the nominal interest rate minus the inflation rate. Currently, nominal interest rates are low or even negative and the inflation rate is roughly 2%, such that real interest rates are negative. Gold is a physical object and, therefore, lacks the principle of interest (by definition). So, low or negative real interest rates are – almost by definition – beneficial for the gold price.
Specifically, the correlation between the gold price and real 10-years US interest rate is strongly negative: -36% over the past 20 years, and -25% over the past 45 years. On the other hand, the correlation between the gold price and the inflation as measured by the CPI (Consumer Price Index) is slightly positive: +4% over the past 20 years, and +13% over the past 45 years.
If inflation rises, then the real interest rate decreases, so gold prices rise. For this reason, gold is sometimes called an ‘inflation-hedge’, because gold keeps its physical value in the future while cash depreciates due to inflation. Note that if you want to use gold, in most situations, it has to be converted to cash which is vulnerable to currency risk and transaction costs.
In short, another reason for why invest in gold is because you want to protect your money from inflation.
- Effect of monetary policy on gold
The monetary and fiscal policies of central banks and governments – especially the central bank of America, the FED – have a strong influence on the gold price. Namely, central banks determine for a large part directly the real interest rate and the strength of the US dollar. Currently, most policies are focused on a healthy recovery from the corona pandemic.
In short, the reason for why investing in gold can be because you can predict monetary policy and thus estimate whether the gold price will rise. (Predicting human behavior is a world feat in itself 😉 ).
Of course, other factors play a role as well in the determination of the gold price, but they are much less relevant. Examples are the sentiment of investors and geopolitics, such as the initiatives of Russia and China to mine more gold.
As shown in Figure 1 above, the gold price recently decreased abruptly between May 2021 and July 2021. What happened? First of all, the FED surprisingly announced two increases in the nominal interest rate in 2023, while it was anticipated that there will be only one increase in 2024. Consequently, the real interest rates will increase within two years and, due to the negative correlation, gold prices will decrease in the near future.
Secondly, the FED revised their forecast of GDP growth from 6.5% to 7.0% and announced an increase in the inflation from 2.2% to 3%. As a result, the US dollar rose by 2% the days after these announcements and, due to the negative correlation, gold prices depreciated immediately. On the other hand, if inflation rates are going to be persistently high, then gold prices may see a rise. But, overall, these announcements are bad for gold as an investment, even for the coming years.
Also, gold mining companies are performing badly. For example, past year, the NYSE Arca Gold Miners Index decreased by -15.19%.
On the other hand, gold still has attractive properties in terms of stable volatility compared to equities and bonds, even during the COVID-19 crisis. The annualized weekly volatility of gold during 2020 was roughly 18%, while US equities had a volatility of 26%. From a long-term diversification perspective, this is an additional argument for considering gold as an investment in your portfolio. However, it is doubtful whether this stable volatility outweighs the gloomy future of gold returns.