Why Invest in Gold?
Historically, gold has been a stable store of value in times of uncertainty and crisis. Going back to ancient times, gold has retained its value through wars, famine, pestilence, plague, and even the collapse of entire civilizations.
Individual currencies rise, fall, and become worthless over the years. But gold continues to enjoy near-universal acceptance as a medium of exchange.
This is why gold deserves a place in any portfolio: Gold tends to shine just when it’s needed most – when everything else in the portfolio is collapsing.
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The term inflation refers to the decline in the purchasing power of the dollar (or any other currency, for that matter) over time. Inflation is like a cancer that eats away at retirement portfolios as you get older: Even if your income stays the same, living expenses keep going up year after year. A given amount of income buys less and less.
We are blessed to have lived in an economy with moderate inflation over the last few decades. But even so, even a relatively modest 3% inflation rate, taken over 30 years, would cut your purchasing power in half.
Put another way, at 3% inflation, something that costs $100 today will cost $243 in 30 years.
But inflation is not a constant – and things weren’t always thus: Americans of a certain age can recall years at a time with double-digit inflation. In 1973, the U.S. inflation rate had fallen to 3%, then rose steadily to hit 12% before receding again…then ramping up to close the decade at 13%.
Over the course of the 1970s, the average inflation rate was 7.25%. Prices more than doubled.
A return even to the 1970s inflation levels for a sustained period would mean that the purchasing power of a 55-year old couple preparing for retirement would be cut in half at age 65, cut by three quarters at age 75, and by 87.5% by the time they turned 85.
If the inflation rates of the 1970s came back, a cart full of groceries that costs $100 today would cost $816.43.
What Causes Inflation?
Inflation is generally the result of too much money chasing too few goods and services. If a dollar is easy to come by, then its value tends to be worth less. People competing for goods and services will quickly bid up the price.
Occasionally, the price of a given commodity will spike due to shortages or to the fear of potential shortages. For example, gas prices can go up as a result of a conflict in the Persian Gulf. But in the main, nationwide inflation is the result of a glut of money in relation to the available supply of goods and services.
Many things can cause this:
- Big federal budget deficits. These cause markets to price in an expectation that the government will have to inflate the currency just to pay off debts with cheap dollars. They also tend to overheat the economy -- in the short term, anyway. In the long run, those debts must be paid.
- Fed Quantitative easing. This is one of the processes by which the Federal Reserve Open Market Committee attempts to stimulate the economy. They buy up Treasury bonds and other securities from banks, and credit their accounts with money that they can then lend out – many times over. This directly increases the money supply. It also generally pushes bond prices up, in turn reducing interest rates, making it cheaper to borrow money.
Congress and the Federal Reserve are aggressively both pursuing deficit spending and quantitative easing. This may be necessary in the short-term to avoid a deflationary spiral. But in the long run, these actions lead to inflation.
- Low interest rates. Prolonged periods of very low interest rates also contribute to inflationary pressures: If it’s very easy and cheap to borrow money, people will do just that – bidding up prices as they compete with each other to buy goods and services.
- Big bull markets in stocks. When too much money is flowing into the stock market, or when people get overly optimistic, it can create a “wealth effect,” where confident consumers increase their spending. In late stages, they may overextend themselves on margin debt, credit cards, and home equity loans. All that money sloshing around tends to push prices up.
- The Printing Press. Sometimes, governments can take it on themselves to just print money, and then use these notes to pay their debts. Firing up the printing press to create more currency without backing it with real wealth creation is usually a disastrous decision. But it's very tempting for politicians in the short-term. In the United States, we have an independent Federal Reserve that controls the money supply. But not all countries have a truly independent central banking system.
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As a result, Americans have not gone through a real period of hyperinflation. But it is a possibility: Venezuela saw inflation rates as high as 1.7 million percent in 2018. Zimbabwe’s official inflation numbers hit 2.2 million percent in 2008.
Germany’s Weimar Republic saw inflation of over 20% per day, for a period in 1923. At the end of that hyperinflationary period from 1919 to 1923, it was said, you needed to take a wheelbarrow full of Deutschmarks to the store to buy a loaf of bread.
Inflation was so bad that German employers had to pay workers twice a day, because the value of their wages would be noticeably less by the time they clocked out. And waiting a week was out of the question.
With any paper fiat currency, the government can easily simply print more – and use those cheapened notes to pay their debt. When the debt is large, as it was for the Weimar Republic in Germany, forced to pay massive reparations as part of the Versailles Treaty that ended World War One, the government has every incentive to do so.
But while any government can print more fiat currency, they cannot print more gold. This is why gold and other scarce commodities retain their purchasing power during periods of high inflation.
Too Much Money: How a Savings Glut Caused House Prices Inflation, 2000-2007
We saw this clearly in the 2000s, when millions of Chinese families, recently emerging from subsistence-level poverty, saw enough prosperity to form a massive new middle-class. Culturally, Chinese value saving over consumption, and so millions of families deposited trillions into Chinese and global banks.
All that money had to be invested somewhere. Tech had recently imploded in 2000, which turned investors off of stocks and channeled money flows into real estate. Banks were eager to lend on houses – it’s what banks tend to do - and so a global savings glut moved through the system.
Banks, flush with cash from deposits, had to find somewhere to invest it at a reasonable return, and were competing to lend every dollar they could. And so, since times seemed good, they began lending to weaker and weaker borrowers. All of these people bid house prices higher and higher until there was no more margin for error in the system.
U.S. Housing as measured by the S&P Case-Shiller Home Price Series, which had long maintained an average appreciation rate of around 5% over time, shot up 13.64% in 2004 and 13.51% in 2005.
The real estate sector as a whole was wildly successful in 2003 and 2004, rising 38.41% and 30.41%, respectively, in those two years, as measured by the FTSE NAREIT All REITs Total Returns Index.
Real estate returns in 2005 were more modest, with the sector gaining 8.29%, but then it came roaring back, dominating all other asset classes that year with a market gain of 34.35%.
By 2006, U.S. real estate – the darling of the financial media at the time, had become a wildly over-leveraged house of cards. Reasonable investors who understood investment fundamentals were shoved aside, outbid by speculators, until there were no other fools to sell to.
There are many different causes of inflation; This one happens to be an excellent example of how too much easy money flooding the system leads to inflated prices. While housing is a notable example, the same principle applies to any commodity or service.
Too much money flooding the system increases the price of gold, as well. But unlike the dollar in that circumstance, gold tends to retain its purchasing power.
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Case Study: How Gold Helped Protect Investors in Last Recession
As early as 2002, gold was the top-performing asset class as we emerged from the Internet bubble, 9/11, and the resulting recession. Gold gained 21.74% in 2003. Returns on the gold spot price slowed to a 5% gain in 2004, and then came roaring back in 2005 and 2006, with a 17.12% and a 23.92% return, respectively.
When the housing crash came, gold came to investors’ rescue. In 2007, real estate had fallen 17.83% - a devastating loss for over-leveraged investors. But gold prices dominated all other asset classes with a 31.59% return.
When the mortgage bubble finally burst in 2008, U.S. Stocks fell 37%. U.S. housing fell 12%. Corporate bonds fell by 7%. But gold continued to climb, gaining 3.41% that year.
In the seven years from 2005 through 2011, gold was either the first or second-best-performing asset class in the market for six years and the third-best performing asset class for the other year.
And then it was gold’s turn to shine.
Gold During Coronavirus
Gold is a vital inflation hedge and provides ballast for portfolios during times of crisis. This is why it deserves consideration in any long-term portfolio. The current coronavirus crisis is a good illustration.
At press time (April 21st, 2020), gold has once again been resilient: While the S&P 500 has lost more than 12% year-to-date, gold prices are up by nearly an equal amount, rising to $1,680.70 per ounce, from $1,514.75 at the beginning of January.
Don’t Try to Time the Market.
One thing to note: Don't try to guess when gold prices will take off. The data shows that gold prices start outperforming well before the broad investing public perceives any financial crisis. If you wait until economic problems are clearly evident, you risk missing out on a big chunk of gold's diversification value.