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Gold: Should You or Shouldn’t You?

March 30, 2012 by Editor, InvestingForMe

I must confess. I’ve never been much of a gold bug so my answer to that question might not be the more common response. And I admit I’ve never understood how the market values gold or the reasoning behind holding gold.


How is the Value of Gold Determined?

Good question. Owning gold doesn't pay an investor any income while you hold it (no dividends, no interest). So, investors can’t use cash flow or yield to estimate the value of an ounce of gold.

Gold by itself doesn’t produce anything. It doesn’t manufacture anything. It doesn’t create any new technologies or processes. It doesn’t create any revenue or profit. So, we can’t use the typical business valuation models to determine the current and future value of it.

Also, unlike most other metals and commodities, gold isn’t consumed – it’s horded. So, gold is mined, refined, and circulated and it never disappears. That means then that the supply of gold is always increasing.

Gold’s Value Historically: a Fear Trade

Investors almost never think to buy gold when times are good. When the economy is doing well, stock markets and real estate are appreciating in value, gold is never thought of as an investment opportunity.

History demonstrates that as an investment, gold gains popularity as investors are told to fear some future outcome as in the following two scenarios:

  • That future inflation will increase and thereby erode an investor’s financial wealth.
  • Paper-based currencies will depreciate, as central banks/government treasury departments continue to print money without restrictions, thereby eroding the purchasing power of savings.

Both these fear trade scenarios are what the investment industry refers to as invisible killers because the investor never actually sees their negative influences in their investment statements or pay cheques. Both interestingly work silently and unseen to diminish an investor’s savings.

Gold’s Recent Makeover to a Legitimate Investment

Recently, however, gold has been attempting to cross over from its historical status as a fear trade into the world of legitimate investing, right along side bonds, common shares, mutual funds, ETFs and preferred shares. We can see evidence of this makeover reconstructing with pronouncements such as the following from such organizations as the World Gold Council (WGC):

Gold is a foundation asset within any long-term savings or investment portfolio. For centuries, particularly during times of financial stress and the resulting 'flight to quality', investors have sought to protect their capital in assets that offer safer stores of value. A potent wealth preserver, gold’s stability remains as compelling as ever for today’s investor.

So, will gold actually manage to successfully make this transition into a legitimate investment? Only time will tell.

Tracking Gold’s Recent Value: Effects of the Sudden Makeover

So, how does the market presently determine the value of gold? Currently, it’s determined simply by the amount of money chasing it. The market value of gold goes up when the amount of money chasing it increases, and it drops when the flow of money decreases – a pattern obvious to anyone paying attention for more than a minute.

Let’s take a look for ourselves. If we follow the price of gold as outlined in the World Gold Council chart below, when would you say the price began to take off the last time? 

 

 

Looks like the price of gold began to take off at the end of 2004. So why did gold prices suddenly begin to rise? Did the amount of money chasing gold suddenly increase?

Although retail investors had access to a couple of gold Exchange Traded Funds (ETF) (Central Fund of Canada and Gold Bullion Securities in Australia) prior to 2004, these options were not well known and most investors desiring to invest in gold pretty much had to buy physical gold in the form of bars and coins. Interestingly it was not until 2004, when the new gold ETFs began to pop-up everywhere and investors suddenly began to hear sales pitches to invest in these new products from the investment industry, that the price of gold began to rise.

In fact, up to 2004 the WGC summarized gold demand from investors simply as Bar & coin retail investment. But by 2005, the retail investment demand for gold was growing so fast the WGC had to create a separate entry just to track retail investment in Gold ETFs & similar products. In 2005, the total investment demand was 593.6 tonnes and this has grown steadily to 1,640.7 tonnes in 2011.

According to WGC reports the demand for gold is attributed to three categories. For a comparison, let’s look at the demand for gold in 2005 and 2011:

 

Demand for Gold (tonnes):20052011% Change
 Jewelry: 2,707.2  1,962.9 - 27.49%
 Industrial/Dental/Technology: 430.6463.5+7.64%
 Investment:593.61,640.7

 +176.40% 

      
Total Gold Demand:3,731.44,067.1+8.99

 

So, as the historical data paints the picture, if it weren’t for the increased demand from investors it’s questionable whether the demand for gold and its price would have increased at all during the past seven years.

Buying Gold? Think Twice: Check the Line

When it comes to deciding if you should buy an investment in gold, there’s a pretty simple rule to remember. It’s called the Dumber Guy Rule.

In the investing world, when an asset’s market price is solely dependent upon the amount of money chasing it, its market price is said to be subject to the dumber guy rule, where an investor buys the assets hoping some dumber investor will be willing to pay more for it at some future date. This may seem like a silly rule, however, for a number of asset types the dumber guy rule is a legitimate investment rule and is not meant to be derogatory. It simply implies that when the asset does not

  • pay an income,
  • generate revenues or profits on its own,
  • create new technologies or processes, or
  • get consumed,

… then the asset’s market price is solely dependent upon the amount of money chasing it.

So, if an asset’s price is climbing, then you might be able to make some money by buying it because a rising price almost always ensures that there will be a dumber guy ready to pay more at some point in the future.

But … buying assets that are subject to the dumber guy rule is always tricky and your success often depends upon your timing. Are you at the front of the line or closer to the back?

Unfortunately it’s pretty safe to say that usually by the time you read about an asset in the news, the line has been in place for a while and joining in will usually put you closer to the end of the line than you think.

So if you are buying gold, you might want to check out how many investors are in front of you in the line.

You don’t want to be the last Dumber Guy!

 

(Published by RateSupermarket.ca)

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