Gold as a Financial Asset - Clear Finances

People have got different opinions as to what gold really is. It can be defined as an investment, savings, an insurance policy, a way to get rich, or even a pet rock. All of those can be simultaneously true. However, in this post, we will analyze gold as a financial asset.

Introduction

Ever since gold reached $2000 per ounce in mid-2020, it has been talked about again in the financial media. We could say it has regained some of its popularity.

Things like inflationary risks, historically low real interest rates, economic and political instability, and massive monetary debasement have all contributed to the rally in precious metals. And almost all those issues have something in common: the monetary policy of central banks.

In this post I am going to talk about gold as a financial asset. It will not be a criticism of other asset classes that are available to invest, quite the opposite. The key is diversification. The risk-reward profile of gold is best when we combine it in a portfolio with stocks, real estate, bonds, cash, and other commodities.

To analyze whether it is convenient for us to invest a portion of our portfolio in gold, it is important to understand what type of asset gold is, which role it plays in the financial market, and against which assets it competes. We will also discuss how we can invest in gold.

In a separate post, I go over 8 reasons why you should invest in gold.

Is Gold a financial asset?

The main difficulty in deciding whether we should invest in gold is to understand what it is. The problem is that there is a lot of ignorance about it, even among professionals in the financial sector.

Many people often say gold is a safe haven asset, which is true, but that does not tell us much. Gold is also a commodity. And while that is true in a practical sense, the percentage of gold mined that is used in manufacturing process is extremely low. Hence it is not like other commodities.

In its strictest and historically correct interpretation, gold is money. And though it may sound surprising to some, we only need to look at history to realize that.

Gold has been used as money for more than 5,000 years. In fact, the last half a century has been the only historical time in which gold has not been used directly as money in any country. The current era started when the United States abandoned the gold standard in 1971. Notwithstanding that fact, it has continued to be used as a store of value by both central banks and investors.

What we use today as money (US Dollars, Euros, Pounds, Pesos, Yen, etc.) is nothing but fiat currencies. They are not backed by anything, other than the belief they will be accepted by other people in the future.

It is indeed a useful creation, but the risk exists that those issuing that money (governments and central banks) will abuse their power, devalue the currency too much, and at some point force people to stop trusting it. We simply need to consider the fact that fiat currencies have existed for thousands of years. And all of them have eventually lost all their value and disappeared.

Whenever a currency has collapsed, society has gone back to using gold and silver as money. Precious metals have the advantage that they cannot be created into existence. That is why they have been honest and sound money for thousands of years. Why should we work in exchange for something that governments can create out of thin air and devalue at any time?

As you can see, gold, unlike today’s currencies, is real money. And this is the main reason why central banks keep much of their reserves in gold.

Which assets Gold competes against

This is the part I really wanted to get into. One of the greatest challenges when it comes to analyzing gold is how to compare it against other assets. For example, against the very popular asset class that is stocks.

The obvious answer is that gold and stocks are not really competing investments. Stocks represent productive assets that should generate long-term profits and dividends. Gold is a precious metal that produces nothing, but is expected to maintain its purchasing power in the long run, as it has always done.

It is not a question about which one is better. Historical comparisons will depend on the period we analyze, which stock markets we use, the historical context, etc. And that is of little use. What is really useful to understand is that, while on the long run both assets will perform well, in the short and medium run their performance might be very different.

And diversification is a key benefit. If stocks go up, gold is likely to yield mediocre results. If stocks have a bad time, gold is likely to do well. And therein lies the great advantage of combining gold and stocks. Keeping attractive expected returns with lower overall risk. Gold and stocks complement each other.

If we want to look for a true competitor to gold, we will find it national currencies (fiat currencies) and government bonds. Let us see why.

The comparison with fiat currencies is obvious. Both gold and fiat currencies represent forms of money. The good thing about currencies is they offer greater stability in the short term and may pay you some interest while you hold them. Gold is better in the long run, as it cannot be devalued, but its price can fluctuate in the short run.

As for government bonds, these represent nothing more than the promise to receive fiat currency in the future, both in the form of interest payments and when we get our principal back.

The problem is that the interest government bonds offer has been way below the inflation rate for almost two decades. Gold also does not pay interest to hold it, but it retains its purchasing power much better.

Comparing gold with corporate bonds (or peripheral European sovereign bonds, such as Spanish or Italian government bonds) is tricky, precisely because they have credit risk. Hence, we can debate whether it is better to hold gold, US dollars, US treasury bonds, euros or German government bonds, since none of those have credit risk.

Consequently, next time you see someone compare gold to stocks, remember that it is the wrong comparison. Stocks benefit from economic growth, moderate inflation, and monetary expansion as long as there is stability. Gold benefits from high inflation, inflation risk, low or negative real interest rates, currency crises and geopolitical tensions.

How to invest in Gold

Finally, if we are ready to invest in gold, we should decide how. If you have never considered that before, you may be intimidated by the idea of having a substantial amount of gold at home. And that is a legitimate concern! But do not worry because there are several alternatives.

The first option is obviously to buy gold and keep it yourself at home. There are many online bullion dealers, such as Coininvest (not sponsored), and their margins are quite small (we can buy gold for between 3-5% above the international price of gold in the financial markets). Just make sure you buy from a reputable dealer.

If you go for that option, I would suggest that you buy gold bullion, that is, normal coins and bars. Do not buy historical coins or numismatics as that is more like investing in collectibles, and additional knowledge is required for that.

The second option is to buy physical gold but have it stored in a secure place. Most online gold dealers offer this service. This eliminates the risk that it might get stolen. The cost of custody is quite small, and you always have the option to have the metal delivered to you if you choose to.

Finally, if you want more convenience, you can invest in a gold ETF. There are many different asset management companies that offer such funds, including Blackrock, Wisdom Tree and ZKB. Simply go to your online brokerage account and search for gold ETFs.

Gold ETFs are the most liquid and convenient option to invest in gold. It is also the cheapest, since they trade practically at the spot price of gold. However, some investors are against them since they do not offer something quite valuable: the option to have some of our wealth outside the financial system.

Conclusion

I hope this post has helped you understand the role gold plays in a portfolio and how it compares with other assets. My suggestion is that you keep learning about the markets to be able to make your own decisions and feel comfortable with them.

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