Gold has been a valuable precious metal since the days of ancient Egypt. It has been used as currency, for making jewellery, and as a medium for creating beautiful artwork. Furthermore, the properties of gold and the difficulty of mining it has made it a precious metal of high monetary value. This is why people invest in it.
Investments in gold are promoted as a way to protect against:
- Inflation – When inflation occurs at too fast a pace, real purchasing power declines in direct proportion to the value of currency and retail prices. Inflation causes prices to go up, therefore reducing the real purchasing power of the same amount of money. Gold becomes more valuable as purchasing power declines.
- Deflation – Conversely, deflation can affect securities and equities by reducing their value. When securities and equities fall, the value of gold also increases.
- Currency Devaluation – World currencies are bought and sold on the open market every day. If a country's currency is devalued on these markets, it could spell an economic downturn. Such conditions nearly always increase the value of gold to at least some degree.
Investors can be tempted to purchase gold if they fear rough economic times ahead. That's not necessarily a bad strategy. However, there is a very important caveat: you cannot use gold to conduct everyday transactions. In other words, the market is not going to accept payment in gold when you need a loaf of bread and a pound of coffee. Gold is not practical as currency in times of economic distress. Therefore, it has to be liquidated to be useful.
What Drives the Price of Gold
Gold is a commodity in the truest sense of the term. Its price is controlled exclusively by supply and demand. The more in demand gold is, the higher the price climbs. So what drives the price of gold? There are four primary factors:
- Production Costs – Since the turn of the 21st century, gold production around the world has declined. It's not that the world is running out of gold; it is that all of the reserves close to the surface of the earth have been pretty much exhausted. Miners now have to dig deeper and work harder, thus increasing production costs. Higher production costs mean a higher retail and investment value.
- The US Dollar – The US dollar is the standard currency of international trade. When the dollar is strong, forex markets are alive with investors purchasing them in large volumes. When the dollar is weak, investors are likely to pull their money out of currency and put it into gold. Therefore, the value of gold tends to track inversely with the value of the US dollar.
- Central Banks – The world's central banks need to hold a certain amount of reserves in order to maintain liquidity. They hold cash for this very reason. But they also tend to hold gold in reserve to account for fluctuations in currency values. As individual investors, central banks view gold as a way to protect against currency devaluation. As central banks seek to increase their gold reserves, they drive the price of gold up.
- Market Demand – Gold is a precious metal that is used extensively in jewellery manufacturing. But did you know that it is also used in medical devices, high-end electronics, and other consumer goods? Indeed, there is a heavy market demand for gold among manufacturers. Their demand directly affects the price of gold on the open market.
Is gold a good investment for you? It really depends on your financial position and your investment goals. It is foolish to assume that gold is automatically good because it's a precious metal. It may be good for your portfolio under the right conditions, but it might also prove to be a detriment.
When investors do choose to purchase gold, it must be with the understanding that gold is not the be-all and end-all. Diversification is still important. It's okay to put some money in gold as long as the remaining financial resources are spread across other assets as well.