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Getting to Know Your Gold

By  +Follow February 19, 2014 9:00PM
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“I know what gold does to mens' souls.”

That quote, from the classic film The Treasure of the Sierra Madre, may cast more light onto the gold market than some would like to admit.

For thousands of years, gold has been more than just worth money, it was money. The metal has held its value through the rise and fall of countless empires and has been coveted to one degree or another by virtually every human society throughout history. It remains totally unique in the world of commodities, a product that defies classic market logic in many ways.

However, despite its somewhat bizarre relationship with people’s imaginations over the centuries, gold still holds/stores value, even after global economies have shifted towards digital markets and paper currencies. And a savvy investor can potentially make (or lose) a fortune speculating on its price.

So here’s a closer look at gold, the metal that’s always toyed with men’s souls.

Why do we Care About Gold?

Precisely why gold came to be considered a symbol of wealth, much less a store of value virtually across the globe, is not a question with a completely logical answer. Gold is extremely soft and malleable, so much so that a single ounce can be beaten out into a 300-square-foot sheet that’s transparent to the human eye. It’s also incredibly dense, with a single cubic meter weighing 19,300 kg (lead, by comparison, is only 11,340 kg per cubic meter).

So one has to stop and wonder: what did our ancient ancestors see in this stuff? Its malleability is pretty astonishing, but it also makes gold utterly useless in building tools or structures. And its weight means carrying it around was extremely difficult.

And yet, throughout the course of history, any number of civilizations the world over have placed value on the metal. Golden artifacts found in the Varna Acropolis in present-day Bulgaria have been dated to between 4,600 and 4,200 B.C.

So why did one of our stone or bronze age ancestors ever decide to start dedicating some portion of their nasty, brutish, and short lives to smelting this rare but largely useless metal?1

Soft, Shiny, and Rare

The obsession with gold can be traced to a few factors; perhaps none more relevant than its rarity. Gold is extremely hard to come by, with only 174,100 tonnes having been mined in the entirety of human history. In fact, geologists estimate that the majority of the world’s gold supply lies near the earth’s core, where it would have settled during the planet’s formation due to its considerable density (and where it will most likely remain totally inaccessible no matter how good mining technology gets), and that the vast majority of the world’s recoverable yellow metal can be sourced to meteorites. From there, it’s simple market economics: low supply increases value.

And while gold may lack utilitarian applications to drive the demand side of that equation, it does have other qualities that have made people covet it over the years. It’s shiny, for instance, displaying lots of luster. And that shine stays put: gold doesn’t tarnish. The metal is largely nonreactive and isn’t affected by exposure to air or moisture like other metals. This, combined with its incredible malleability, makes it perfect for jewelry or other decorative purposes. It’s as Nietzsche described it: “But tell me: how did gold get to be the highest value? Because it is uncommon and useless and gleaming and gentle in its brilliance; it always gives itself.”

Somewhere along the line gold ceased being a symbol of wealth and just became wealth itself. Gold was used as currency for hundreds of years, then gradually transitioned into being used to back currencies under the gold standard. To this day, there are those who believe that we should return to said gold standard and that gold, with its long history of holding value, is always a safer bet than paper/ fiat currencies that rely on the backing of central governments for value.

Gold as an Investment

Regardless of why gold has a history of holding value, the fact that it does is all that matters to the modern investor. The current gold market is dominated by two uses: jewelry and investing. Half the world’s gold production is funneled into jewelry, 40 percent into investment purposes, and just 10 percent into industrial uses.

This makes gold distinctly different than other precious metals. Silver also has a similar history to gold, and platinum is actually rarer, but both of these metals are subject to market demands based on a variety of industrial uses. Gold’s price, on the other hand, is driven almost entirely by speculation, making it an intriguing investment device.

While the rate of production can cause changes in price, the biggest factors are broader, macroeconomic forces and market sentiment. Something that became pretty clear when dozens of businesses buying up people’s jewelry opened up when gold prices were driven through the roof a few years ago.

What Drives Gold Prices?

Gold’s special/enigmatic relationship with value means that there are several factors that can influence its price. At any given point in time, it can be difficult to determine what factor will be most present in the minds of gold speculators, but each has the potential to drive prices up or down.

The first, and likely the most prominent, is that gold is used as a hedge against inflation. In short, gold’s value tends to move inversely to that of the US dollar, so in inflationary economies, the price of gold tends to rise. This is particularly true when the supply of money increases, as it has consistently these last few years under the Federal Reserve’s quantitative easing program.

Part of this connection can be attributed to the idea that gold is inherently more stable than fiat currencies because its supply is tangibly limited in a way paper money isn’t. Whether or not there’s any truth to this perception, the belief that it’s true can drive gold prices.

Also, on a more practical level, when inflation is high it means the dollar is losing value. And, anyone holding cash is effectively losing money, so they would most likely start looking for somewhere to stash their savings so it’s not depreciating. So, given that gold (typically) not only holds its value but increases in value during period of inflation, it’s actually a pretty smart place to store value if you can correctly anticipate inflation (which, as anyone heavily invested in gold from 2011 to 2013 could tell you, is a lot easier said than done).

Another contributing factor, and one that’s related to the first in many ways, is the use of gold as a safe haven. Gold’s value tends to be at its highest during periods of economic turmoil, periods that also tend to witness falling stock prices. While bonds are the most-used asset class during crashing stock markets or deep recessions, gold is also a popular option.

Finally, gold can also be viewed as a fairly volatile investment vehicle for those in a risk on environment. In some cases, inflationary concerns and crashing stock prices still result in lower gold prices because traders, looking to reduce the risk in their portfolio, move assets away from gold.

Gold: An Investment not for the Faint of Heart

So whether an investor is a bona fide gold bug who’s just CERTAIN the dollar is going to crash and gold’s going to $10,000 an ounce, or a measured speculator interested in diversifying a portfolio already loaded with stocks and bonds, gold can be an interesting investment vehicle.

Caveat emptor, though. Speculating on gold prices can be a pretty hairy market, and one with many, many traders who are extremely experienced and show an interest in the metal that borders on obsession. And given that the price is driven almost entirely by speculation, the gold investor can be in for a pretty wild ride if they’re not careful.

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1It’s worth noting here that gold is an excellent conductor of electricity. Not something that our ancient ancestors would have picked up on lest an unfortunate accident with a crown and a lightning storm, but one potentially useful application for the metal.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow February 19, 2014 9:00PM
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