I have been digging up information from a lot of sources on the subject of investing in gold after my last post “Gold as Investment: The Basics“. I have to admit that it’s a bit intimidating to find stuff about gold investing that really makes sense for a rookie like me. I constantly came across many articles that say something to this effect: “gold is a hedge against inflation” or “gold is an insurance against inflation”. However, I had difficulties in understanding some of these terms, and most articles raised more questions for me like “what do you mean by insurance against inflation” and “what has gold got to do with it”? I will try to address some of these questions in this post in an overly simplified manner.
Gold prices: First and foremost, it is important to understand that gold is a *global* commodity. The price of gold is set by considering the global supply and demand. The term “supply and demand” incorporates the difference between annual gold production from gold mines and annual demand, as well as, the changes in public sentiments. This is slightly different than other commodities like onions or gasoline. Gold is not *consumed* in the same way as most other commodities. Till date, about 155,000 tonnes of gold has been already mined (as compared to just about 2500 tonnes produced annually) and almost all of it is still lying around with people (or governments) in some kind of physical form (usually referred to as “aboveground stock”). Because of this huge aboveground stock, gold prices can change in two ways: 1. gold prices can rise or fall if the production from the mines is decreased or increased, and 2. prices can also rise or fall if people (or governments) suddenly start buying or selling gold (even if gold production is held steady).
In addition to the supply-demand factors, the price of gold also depends on the value of the currency with which you are buying the gold. This is a bit complicated and I will try to explain it in the following section, while I explain why gold is considered as an insurance.
Before I end this section, I want to quote an interesting take on why gold is something more than just a commodity (this may also explain why gold prices are more difficult to understand than other commodity prices). The excerpt is from an article titled “Understanding the gold price” by Paul Van Eeden:
If gold is a commodity like rice or aluminum, then it should be priced as such. It would seem that under such circumstances, gold is the most overpriced commodity in the world. The value of gold as a commodity stems from its physical properties: electrical and thermal conductivity, resistance to corrosion, malleability and ductility. The biggest market for gold will be in the electronic industry where it will compete with other metals, notably copper. If gold were to truly compete with copper in mass production of electrical components then the price of gold would have to be competitive with the price of copper. Copper trades for around $0.80 a pound and gold for more than $4,000 a pound. This means that the gold price would have to drop to less than $0.06 (six cents) an ounce to be in the same region as the copper price. Obviously gold is not being priced as a commodity. There is a demand for gold that inspires people to pay substantially more for it than its commodity value. Gold is money.
Gold as insurance: On one of the gold trading websites (Austin Rare Coins and Bullion), I read this:
In the case of the most severe circumstances like high inflation or currency deflation, gold offers you both safety and security.
To understand what such statements mean, let’s consider a hypothetical situation in which the value of 1 Australian dollar (1 AUD) is equal to 1 US dollar (1 USD), and you can buy 1 ounce of gold in 1 AUD or 1 USD. Assume that there is some kind of a supply-demand equilibrium and gold prices are not affected by it. At this time, the price of gold as perceived by a person in the US is $1 (USD) per ounce. Also, it is the same $1 (AUD) per ounce as perceived by a person in Australia.
1 USD = 1 ounce of gold = 1 AUD
Now, assume that the US dollar falls in value (inflation happens - you need more dollars to buy a certain thing/commodity than what you needed before inflation) against the Australian dollar. Let us say that now it will now take you 2 USD to buy 1 ounce of gold or 1 AUD. This has nothing to do with the *global* price of gold and the equation will look like this:
2 USD = 1 ounce of gold = 1 AUD
When this happens, for a person in the US, the price of gold has suddenly shot up by 100% to $2 per ounce, whereas, for the Australians, it is still $1 per ounce. This is where the *insurance* comes into play. If you had just kept your 1 USD as paper money, you buying power would have been reduced to half after the inflation. Whereas, if you had bought 1 ounce of gold before the inflation, you could get 2 USD in return for that one ounce of gold after the inflation…so basically, you could keep up with the inflation by buying gold. This is what is generally meant by “gold as an hedge/insurance against inflation”.
Also notice that for a person in the US who bought gold before the inflation, there is an apparent gain in the net worth due to rise in the gold prices. But, in our example, the global gold prices did not change (Australians are still paying 1 AUD per ounce of gold) so the rise in the prices is just US specific….just goes towards showing that one has to be careful in interpreting historical gold price data based on US dollars.
Btw, sometimes the US dollar gains strength globally in spite of inflation (from what I have read) and makes it even more difficult to understand gold pricing…but things/concepts like those have “not-for-rookies” stamped all over it 
…so I am not even daring to go in that direction.
That’s all for this time.
In the next post of this series we will start with some pros and cons of gold as investment…in a way that will be useful for a someone who is just interested in buying some gold…and doesn’t care much about the dynamics of gold economics (people like me).
Feel free to suggest any corrections/modifications/additions to the above write up in order to make it more useful for people who are starting out in this area.
If you are interested in reading details about gold pricing and it’s relation to inflation and related concepts, here are some references (these are also the references I used for this post):
- Understanding the gold price - by Paul Van Eeden
- Gold as an investment - Wikipedia
- Gold and inflation - by Eric Hommelberg (it will take you a while with this one )
- Gold a commodity? - by Paul Van Eeden
- Gold and inflation by John Lee
- Gold an inflation hedge? - by Robert Blumen
Image source: www.everythinginvestment.co.uk
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I found this (http://en.wikipedia.org/wiki/Gold_standard)Wikipedia article useful in understaning how gold and American currency are conected. In particular this article discusses the concept of the “gold standard” which basically says that “gold is the only universal measure of value, that gold standards prevent inflation by preventing the creation of unlimited money supply in a fiat currency, and that it provides the soundest theoretical basis for a monetary syste.”
Golbguru,
You are doing some serious research on gold. Are you seriously thinking about making a purchase of gold for an investment? Just curious
BTW, your article also points out another interesting way to play gold - currency investments. I keep considering whether the Chinese Yuan will become a good currency play shoudl China stop pegging it to the US Dollar.
Golbguru,
Great post man! I am a new reader to your blog after stumbling upon it through blogtopsites (congrats on #1 by the way), and will start shooting ya over some of my traffic!
I don’t know if you mentioned this, but have you considered GLD as a possible way to play gold? Btw, I am a “20 something” too, see you around!
Nice post! Gold has been recommended by Several friends. I just thought I knew too little to invest in it. It might be a good hatching for the coming economy downturn.
Jon: thanks for the link. I found it useful…and pretty interesting.
Super Saver: Yes, I am planning on getting some gold soon. In fact, all this is a warm up to the actual gold buying experience.
Blain: I am looking at GLD ETF as a possible investment alternative but I do have some issues that need answers…I will probably write about that in the next post in this series. Thanks for the link.
Yannick: yeah…it’s a good hedge for recession too. I think the logic behind that is that stocks can fall down to zero value…almost zero value, but gold never does that. It can have a major fall (depending on market sentiments)…but it will still retain a lot of value as a precious metal.
this is great, i am also researching how to buy gold.
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