Why do people buy gold?

A lot of people are really into gold, and not just for jewellery. People have valued the yellow metal for a long time.

To be a bit more precise I’m thinking about why people buy gold as an investment.

In recent times investors have certainly valued gold. In 2011 it reached a high of $1900 for one troy ounce (31g).

There seem to be two widespread views out there [1]

  1. Gold is a hedge against market downturns.
  2. Gold is a hedge against inflation.

Viewpoint 1 is discussed in this paper.

The sentence below, from the abstract of this paper available here describes the quandary well.

Gold is an important asset, with a market capitalization of $9 trillion—roughly 10% of the combined capitalization of world stock and bond markets. Yet, gold’s role in diversified portfolios is not well understood.

If it makes you feel any better some extremely smart (and rich) investors don’t know either. Again from the paper cited above,

There are widely divergent views on the value of gold, even among expert investors. For example, Warren Buffett believes gold is overvalued and compares the current value of gold to three famous bubbles: the tulip bubble, the dot-com bubble, and the recent housing bust. In contrast, Ray Dalio argues that there will be an ugly contest to depreciate the three main currencies by printing money and investors own a dangerously small amount of gold.

There is a really good peice by Ray Dalio here, who advocates for a bigger role for gold in investors portfolios. He is a very smart guy so certainly worth reading.

On the other hand, Warren Buffet said that gold is,

A hunk of metal that has no real utility other than to people fleeing the dollar.

There is an interesting interview with Jack Bogle, founder of Vanguard and pioneer of low cost index fund investing who I probably agree with on this topic and puts things much better than I could.

Gold and market downturns

Gold and inflation

Measuring inflation accurately is a really tough and interesting challenge. Traditional measures may not fully capture inflation dynamics. I know there is currently a lot of interest in using Amazon price data to measure inflation. See this: http://thewire.fiig.com.au/article/2017/06/20/introducing-the-amazon-inflation-index.

Some (maybe only one, not sure if he is a crank) people think gold is a good hedge against deflation though! See here, https://info.c-loans.com/gold-is-a-hedge-against-deflation-not-inflation

Some people also think that gold is a hedge against inflation, but this article https://www.forbes.com/sites/danielfisher/2013/08/08/gold-not-much-of-a-hedge-for-anything-unless-youre-a-centurion/#73f148a66a74

and this research paper which it references questions gold as an inflation hedge https://www.tandfonline.com/doi/10.2469/faj.v69.n4.1

Conclusion

I’m personally a bit of gold sceptic. Maybe in the future the link between gold being good insurance against bad things might wane in people’s minds and something like Bitcoin (digital gold?) may take its place. I’m a sceptic on Bitcoin too if that is any help!

However, the fact that these views are so widespread makes me think again. There does seem to be something alluring about the yellow metal. The most convincing argument I have seen giving the bull case for gold is that if the central banks of developing countries increase their gold holdings to match that of the U.S (with respect to GDP) there would be incredible demand. From the authors of the paper on gold and inflation,

There is, however, a plausible scenario for the other side of the argument. What if the BRIC countries increase their gold holdings to a level that reflects the U.S. gold/GDP ratio? Our analysis shows that the BRIC gold holdings would have to triple, leading to an accumulation of an extra 4,000 metric tons in reserves. The entire annual world production of gold is less than 3,000 metric tons. Even the most aggressive buyer of gold, China, has managed to increase its holdings by only about 50 metric tons a year over the past 11 years. The demand for an extra 4,000 metric tons would likely lead to higher prices.

There does seem to be some evidence of India buying gold like its going out of fashion. The chart below shows different countries holdings of gold taken from here.

gold reserves by country

I put all the BRIC countries (Brazil, Russia, India and China) on the chart. I didn’t realise that Russia were such big hitters in gold ownership. Brazil on the other hand seems to have less gold than when the series starts in 2000. I’m not sure how accurate the figures are though.

In the end you have to make your own mind up and I’m afraid there are no easy answers.

Bitcoin and Gold

I wanted to bring Bitcoin into this. In some respects Gold and Bitcoin are very similar assets. Both produce nothing, meaning they don’t pay a dividend like some businesses do to their equity holders or interest to holders of their debt.

So why own either? Well store of value.

Their proponents also have an interesting cross-section in some central bank manipulation/conspiracy theories. Believing their asset of choice is pure and can’t be debased.

I’m still trying to understand QE. I know its more than 12 years old, but I am a slow learner! I came across a nice explanation from Joe Weisenthal from Bloomberg

But here’s the problem, the Fed can’t make the money printer go brrrrr like we need it to right now. At least not under its existing legal structure. Because while it can create reserves at the stroke of a key, it does so buy buying assets from the private sector. So if the Fed, say, buys $1 billion worth of Treasury bonds, then yes, some entities in the private sector get $1 billion in reserves. But they’ve handed over $1 billion worth of Treasury bonds to the Fed. And so the net wealth position of the counterparty hasn’t changed. All those charts you see of the Fed’s balance sheet you always see are assets that the Fed has TAKEN away from private holders, leaving their overall balance-sheet position roughly the same. Even yesterday’s historic actions were slightly more aggressive versions of the same principle. You can get cash from the Fed, but you have to sell the Fed something, or pledge some asset as collateral.

I’m kind of surprised that Bitcoin is still allowed to exist by governments. If your heart so desires it you can even trade Bitcoin futures on Wall street thanks to the CME. There are even options on the futures available! I think this product may be a bit controversial in both camps (Bitcoin purists and Wall street) since the underlying price that determine the futures is set in the spot market on the (extremely) lightly regulated cryptocurrency exchanges which I imagine could be manipulated fairly easily by “whales” (a term for holders of a large number of coins).

I can see that Bitcoin has some value. Assume you had 100btc then you could probably find someone via the internet to

People in countries with dictators etc do seem to use Bitcoin and other cryptocurrencies to get around the authorities. There is an interesting podcast on this here. If you have twitter the two presenters, Tracy Alloway and Joe Weisenthal are very informing and amusing follows.

In the same vein, Matt Levine, another Bloomberg commentator wrote about this story in the New York Times,

If you are a cryptocurrency enthusiast living in a brutal dictatorship, and you use cryptocurrency as a way to evade the restrictions and bad economic policies of that dictatorship, and one day the brutal dictator comes to you and asks you to design a cryptocurrency for him, do you think that designing that cryptocurrency for him will usher in a new era of freedom and wise economic policies? Or, you know, not? The answer is “not,” of course, but I appreciated the naive idealism of Gabriel Jiménez, the designer of Venezuela’s Petro cryptocurrency, in this story by Nathaniel Popper and Ana Vanessa Herrero.

Reading

Here is a nice article about the humble origins of Bank of America.

Here is a series of articles about the recent actions taken by the Fed. The guy seems very knowledgeable.

Bill Ackmann got on TV a few days ago in the midst of a market sell off to tout some of his positions (or not according to Bill). Watch his interview and see what you think.

It came out a little later that he had put a big bet on against investment grade and high yield corporate bonds. His letter to investors is here where he describes the trade. It was a very impressive trade but could have easily gone against him.

An aside

I came across New York’s Governor, Andrew Cuomo in one of his updates on the virus. I like him! This clip of his New York branded hand sanitiser is brilliant.. Future presidential material?

  1. Many thanks to Simon Smith for pointing me to some interesting research. Any and all errors here are mine. 

Written on March 26, 2020