Three reasons to avoid gold

It’s often just a flash in the pan

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old is frequently touted as a must-have investment for the most intense of risk-mitigation situations, a “when all else fails” hedging instrument. Indeed, pick an ailment: Inflation? Economic and political crises? The decoupling of the United States and China? Pandemic-fueled collapse of modern society? “Hedge with gold.”

With unprecedented amounts of monetary stimulus being unleashed and the global economy still buckling, multiple countries still engaged in armed conflict or otherwise in crisis, and plenty of shared uncertainty over the future, gold continues to make the rounds as must-have asset. This, despite the reality that it doesn’t consistently hold its value well over time.

Now, in the midst of another meteoric rise in value ($2k+/oz on August 6, 2020), massive central bank accommodations, and COVID-19, here are 3 reasons to actually avoid gold, both as a physical or paper holding, apart from a very small percentage of a well-balanced and diversified portfolio:

  • It’s a highly psycho-emotional asset.
  • There’s no historical evidence that it hedges well against any risk.
  • It has very little practical use.

he yellow metal is a highly psycho-emotional asset. Its pricing doesn’t comply with a supply and demand structure as does that of crude oil, for instance. As all oil-producing nations continued pumping out oil in 2020 despite an existing supply glut, a price war between Russia and Saudi Arabia, and a pandemic-battered global economy, we knew prices would stay low because demand is depressed and there’s an oversupply.

As those dynamics changed — voluntary production restrictions were instituted once again — so did oil’s going price per barrel; it has gone back up somewhat. At what exact price level oil will find itself as time goes on, who knows, but that’s not the point.

The takeaway is that we know that OPEC adjusts its production based on going prices — which transmit information about how heavily oil is being used by big industry and motorists — and to influence those same prices.

During 2020 and the full onset of the pandemic, companies have issued more equity in the face of soaring demand. Tesla is one such example.

With gold the commodity, there is no such relationship between supply and demand. Interestingly enough, as authors Erb and Harvey point out in their scholarly paper “The Golden Dilemma” (2013): Nobody really knows how much gold supply exists above ground (already mined throughout history); nobody really knows how much exists below ground yet to be mined (and changes in technology can change estimates); and the production of gold has been rather constant year upon year.

Indeed, its production is rather insensitive to its price.

This means that in spite of what has already been produced, what could be produced, and its going price, metal mining companies continue to produce a range-bound amount of gold. As the authors note, “Remarkably, the new supply of gold that comes to the market each year hasn’t substantially increased over the past decade [1999–2012] even though the nominal price of gold has risen fivefold.” In other words, miners didn’t opt to produce more to capitalize on higher going prices. Doesn’t that seem strange?

What’s more, of all the three primary uses of gold — jewelry, investment, and technology — only investment in gold seems to have a strong price elasticity of demand, and a positive one, at that. Jewelry has a negative price elasticity of demand (but it’s not that strong), and technology demand seems to be price inelastic.¹

What this means is that demand for gold for making jewelry goes down slightly as the price of gold increases. This makes sense as the raw material, and hence the products, become more expensive. Hence, some customers are simply priced out of the market, since they can’t afford those goods anymore.

Technology demand doesn’t really seem to change much no matter the price; whatever gold is required to make technology products, it is acquired as needed, no matter how expensive the yellow metal is.

However, regarding investment demand, it goes up as the price of gold increases. Consider that. As gold gets more expensive, more people invest their capital in it, chasing positive returns that others have already realized.

This is officially known as momentum investing and, while some would argue it’s a legitimate trading method, others might say that such investor behavior resembles a bunch of lemmings heading toward a cliff.

what does buying gold really buy you?

Psychological peace of mind when it appears as if the world is coming apart at the seams, perhaps. For how long is uncertain, though. We tend to adapt to what at first strikes us as irrational. And if gold sinks in price while you’re holding it, will that help or hurt your sense of psychological well-being?

Moreover, the value of that peace of mind is extremely personal and doesn’t translate well to commercial markets. Physical gold coins cannot be spent easily in modern society. Walking into a grocery store to buy some lettuce with a gold coin will get you some strange looks and most likely no lettuce.

In a truly apocalyptic world, will you finally be able to easily spend your gold for those things you need? How will you and your trading partner establish the trading value of a gold coin in the absence of currencies, governments, and financial institutions such as banks and payment processors? As for the next transaction you have with somebody else, will they agree to the same value of a gold coin as the previous person you did business with? Possibly not.

In such a world, seeds could be of more value than gold, or even plain old survivalist know-how: hunting and gathering, shelter-building, plant identification, and so on.

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Historical prices since gold has been a tradeable asset (inflation-adjusted dollars). Source: MacroTrends.

rom the publication, The Golden Dilemma, we also learn that, historically speaking, gold has not hedged inflation or general crises consistently or frequently. Basically, gold may or may not be a good store of value in bad times. That’s not the kind of hedging instrument to trust and invest in; that’s a gamble.

The authors examine various situations and time periods and find no correlation between rising inflation or even hyperinflation and rising gold prices. As for general crisis-hedging potential, there always seems to be a crisis occurring in this world. Has gold ever been the answer to any of them, a bonafide investment savior?

How have we seen gold behaving as a safe-haven investment in recent years?

  • When the stability of the entire European Union as a world-body was threatened by the failure of Greece’s economy and potential exit from that organizational structure in 2015, gold was actually declining in value.
  • As concerns over China were increasing during its period of severe stock market turbulence in 2015–2016, the price of gold really didn’t.
  • With the worst refugee crisis (Syrian) in history since WWII still underway, the price of gold has remained fairly cool to that.
  • Gold pricing has not appeared to respond much to the disaster that is Brexit.
  • For the entire 2018 calendar year, the price of gold had been oscillating within an extremely narrow band, in spite of all conversations regarding North Korea, Yemen, Syria, Russia, Venezuela, China and trade wars, how Trump obtained the presidency, and any number of other hot-button topics.
  • In the midst of the onslaught of SARS-CoV-2 and a once-in-a-century global health crisis with attendant political and economic fallout, gold is still worth less than in 1980 or 2011, adjusted for inflation.²

Frankly, gold doesn’t seem to be a reasonable answer to any crisis. Will it save us from the climate crisis? A political crisis? A population crisis? A clean water crisis?

Take the following story from The Golden Dilemma on the Hoxne Hoard and how poorly gold may serve as a safe-haven investment in tumultuous times:

A possible second condition for a safe haven [investment] is that during times of stress it should be possible to access the safe haven asset. Consider the famous Hoxne Hoard which is currently on display at the British Museum. The Hoxne Hoard is an example of what can happen when trying to make a safe haven investment. The Hoxne Hoard is the largest collection of Roman gold and silver coins discovered in England. Evidence suggests that the hoard was buried sometime after 400 A.D. by a wealthy family seeking a safe haven for some of its wealth. The 5th century A.D. was a time of great social stress and political turmoil in England as the Western Roman Empire unraveled. The fact that the hoard was discovered in 1992 means that the family failed to reclaim its safe haven wealth. Indeed, the Hoxne Hoard is an example of an “unsafe haven”.³

inally — and this has been touched upon already — gold has little practical use. It’s mostly utilized to make jewelry, then as something to invest in, and then a distant third as a manufacturing input for technology goods. You can’t really spend it in your neighborhood, it’s not that straightforward to borrow against, and you can’t easily transfer its value electronically to pay bills or make purchases.

People who inherit it often don’t know what to do with it, while people who purchase it in coin form do so knowing full well they are not planning on spending it in their daily lives, but rather black-swan style under wild emergency circumstances.

(Personally, I’d like to see that. I reassert that in such times, there will be other things of much greater value than gold coins.)

For those of you who own gold, you may see it confiscated by your government. It has happened before in the United States. Even if they let you keep it, the stuff is impractically heavy and difficult to haul.

Yet, central banks the world over continue to purchase it. Certainly there must practical reasons for that? Well, if so, we don’t readily understand them.

No country is on a gold standard anymore, and some countries are even net sellers rather than net buyers of the precious metal. Of these net buyers, they complete purchases year after year no matter the price, probably because it’s what central banks do. Why interrupt the inertia? Indeed, former Fed Chairperson Ben Bernanke has been quoted as stating simply that it’s because of “tradition, long-term tradition.”⁴

ll this said, one sure benefit of gold is that it is poorly correlated with other assets. Its use as a means of further diversifying a well-balanced lazy portfolio by a suggested slice of approximately 2%, give or take, is worth something.

If it leads to an increase in the value of your portfolio, great, but don’t count on it as some type of infallible lifeline when disaster strikes wide. Better off knowing how to feed and shelter yourself, and meet your other most basic of needs first.

Footnotes

¹ Price elasticity refers to the degree or strength of consumption of a good relative to its cost.

² Valenta, Philip, MSF. “Gold was worth more in 1980.” The Innovation (2020).

³ Erb, Claude B, and Campbell R. Harvey. Working Paper 18706: “The Golden Dilemma.” National Bureau of Economic Research (2013).

⁴ Former Federal Reserve Chairperson Ben Bernanke, in response to questioning from Senator Ron Paul at a congressional hearing of the House Financial Services Committee (2011).

HedgeHound

Hedge…everything.

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