Gold as an investment

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Reserves of foreign exchange and gold

Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold as a hedge or safe haven against any economic, political, social or currency-based crises. These crises include investment market declines, burgeoning national debt, currency failure, inflation, war and social unrest. Investors also buy gold early in a bull market and sell it before a bear market begins, in an attempt to gain financially.

Gold price

Price of one troy ounce of gold in US Dollars 1968 – 2008. (Note that this graph in nominal USD terms may mislead. In real terms, the peak value was 1981 by some margin).

Gold has been used throughout history as a form of payment and has been a relative standard for currency equivalents specific to economic regions or countries. After World War II a gold standard was established following the 1944 Bretton Woods conference, fixing the gold price at US$35 per troy ounce, or, in effect, pricing the U.S. dollar as 1/35th of a troy ounce of gold.

The system existed until the 1971 Nixon Shock, when the US stopped the direct convertibility of the United States dollar to gold. Since 1919 the usual benchmark for the price of gold is known as the London gold fixing, a twice-daily (telephone) meeting of representatives from five bullion-trading firms. Furthermore, there is active gold trading based on the intra-day spot price, derived from gold-trading markets around the world as they open and close throughout the day. The following table sets forth the gold price versus various assets and key statistics:

In March 2008, the gold price exceeded US$1,000^[7], achieving a nominal high of US$1,004.38. In real terms, actual value was still well below the US$599 peak in 1981 (equivalent to $1417 in U.S. 2008 dollar value). After the March 2008 spike, gold prices declined to a low of US$712.30 per ounce in November. Pricing soon resumed an upward momentum by temporarily breaking the US$1000 barrier again in late February 2009 but regressed moderately later in the quarter.

After fluctuation returned near the US$1,000.00 mark in mid-September 2009, international gold markets peaked at US$1,023.30. Pricing later declined moderately again in late September 2009, falling back to US$991.70 for the week ending on September 25, 2009.

Later in 2009, the March 2008 intraday spot price record of US$1,033.90 was broken several times in October, as the price of gold entered stages of new highs.^[8][9] Current 2009 peaks have been attributed to media speculation^{[citation needed]} expressing both: inflation will accelerate; and the likelihood of an end to dollar hegemony. India had recently purchased over 200 tons of gold from the IMF contributing to a surge in gold prices in November 2009.

Financial commentator Jim Rogers predicts that gold will reach US$2000 per troy ounce without citing a time frame.^[10] Some analysts attribute this to central banks diverting their reserves away from US dollars.^[11] However, economics professor Nouriel Roubini sees another investment bubble that will burst spectacularly.^[12]

Factors influencing the gold price

Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price.^[13][14] At the end of 2006, it was estimated that all the gold ever mined totaled 158,000 tonnes.^[15] This can be represented by a cube with an edge length of just 20.2 meters.

Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.^[16] According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes.^[17] About 2,000 tonnes goes into jewellery or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds.^[17] This translates to an annual demand for gold to be 1,000 tonnes in excess over mine production which has come from central bank sales and other disposal.^[17]

Central banks and the International Monetary Fund play an important role in the gold price. At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves.^[18] The Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 400 tonnes a year.^[19] European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period.^[20] Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005.^[21] In early 2006, China, which only holds 1.3% of its reserves in gold,^[22] announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks. India has recently purchased over 200 tons of gold which has led to a surge in prices.^[23]

Bank failures

When dollars were fully convertible into gold, both were regarded as money. However, most people preferred to carry around paper banknotes rather than the somewhat heavier and less divisible gold coins. If people feared their bank would fail, a bank run might have been the result. This is what happened in the USA during the Great Depression of the 1930s, leading President Roosevelt to impose a national emergency and to outlaw the ownership of gold by US citizens.^[24]

Low or negative real interest rates

If the return on bonds, equities and real estate is not adequately compensating for risk and inflation then the demand for gold and other alternative investments such as commodities increases. An example of this is the period of Stagflation that occurred during the 1970s and which led to an economic bubble forming in precious metals.^[25][26]

War, invasion, looting, crisis

In times of national crisis, people fear that their assets may be seized and that the currency may become worthless. They see gold as a solid asset which will always buy food or transportation. Thus in times of great uncertainty, particularly when war is feared, the demand for gold rises.^[27][28]

Reasons investors buy gold

Investors generally buy gold for two main reasons: because they believe that gold prices will continue to rise and thus that they can gain financially, and/or as a hedge or a perceived safe haven against any economic, political, social or currency-based crises. Of course prices can fall as well as rise, so investors must make a best guess on what the future holds.

Methods of investing in gold

Investment in gold can be done directly through bullion or coin ownership, or indirectly through gold exchange-traded funds, certificates, accounts, spread betting, derivatives or shares.

Investment strategies

Fundamental analysis

One troy ounce along with the certificate

Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the yearly global gold supply versus demand. Over 2005 the World Gold Council estimated yearly global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes.^[29] While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity.^[13][14]

Gold versus stocks

Dow/Gold Ratio 1968-2008

The ratio of the Dow Jones Industrial Average index divided by the price of an ounce of gold. A surrogate index was used to generate all points before 1897. Note: The vertical scale of this chart is logarithmic.

The performance of gold bullion is often compared to stocks. They are fundamentally different asset classes. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e., growth from anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil. The attached graph shows the value of Dow Jones Industrial Average divided by the price of an ounce of gold. Since 1800, stocks have consistently gained value in comparison to gold in part because of the stability of the American political system.^[30] This appreciation has been cyclical with long periods of stock outperformance followed by long periods of gold outperformance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear market) and proceeded to post gains throughout the 1980s and 1990s. The peak of 1980 also coincided with the Soviet Union's invasion of Afghanistan and the threat of the global expansion of communism. The ratio peaked on January 14, 2000 a value of 41.3 and has fallen sharply since.

In November 2005, Rick Munarriz of Motley Fool.com posed the question of which represented a better investment: a share of Google or an ounce of gold. The specific comparison between these two very different investments seems to have captured the imagination of many in the investment community and is serving to crystallize the broader debate.^[31][32] At the time of writing, a share of Google's stock and an ounce of gold were both near $700. On January 4, 2008 23:58 New York Time, it was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per ounce and a share of Google closing at $657 on U.S. market exchanges.

On January 24 2008, the gold price broke the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March 13, 2008 amid recession fears in the United States.^[33] Google closed 2008 at $307.65 while gold closed the year at $866.

The cost of holding onto tangible gold yields risk. Because of gold's value, that risk must be hedged by secure protection. Because of this additional cost and security risk, some opt for mutual funds.^[34]

Technical analysis

As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price.

Using leverage

Bullish investors may choose to leverage their position by borrowing money against their existing [gold] assets and then purchasing [more] gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases the corresponding risk of capital loss if/when the trend reverses.

Price speculation

Since April 2001 the gold price has more than tripled in value against the US dollar, prompting speculation that the long secular bear market (or the Great Commodities Depression) has ended and a bull market has returned^[35]. A World Gold Council report released on February 18, 2009 showed physical gold demand rose sharply in the second half of 2008.

Identifiable investment demand for gold, which includes ETFs (exchange-traded funds), bars, and coins, was up 64 percent in 2008 over the year before.^[36]

In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio, an indicator of how bad a recession is and whether the outlook is deteriorating or improving, to a value well below 4. The ratio fell on February 18, 2009 to below 8. ^[36] During these difficult times, many investors tried to preserve their assets by investing in precious metals, most notably gold and silver.

See also

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References

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