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Why Investors are Flocking to Gold

by Matt King, CFA, Chief Investment Officer, Managing Director

March 2011

If you are wondering why gold is garnering attention these days, here’s why. Since July 1999, the metal has risen in price from $253/oz. to about $1,420/oz. today. That’s a total return of over 460% during that time. But it’s not just the outsized returns that have been catching investors’ attention. To truly understand gold’s popularity as an investment, you have to view at it as a currency.

Gold is in fact a currency. Gold coins were used as a medium of exchange hundreds of years BC. And up until 1971, global currencies were directly or at least indirectly tied to the price of gold. Gold has long been used as currency because it has all of the characteristics of a great currency. It’s indestructible. It’s easily reshaped, molded, and divided into smaller pieces. It’s transportable, given that a few ounces of the stuff has always been a meaningful sum of money. But the most important reason for why gold makes a great currency is that it’s rare and hard to find, making it an excellent store of value and a hedge against inflation.

Since 1913, the dollar has lost 95% of its value. One 1913 dollar is now worth about 5 cents. Meanwhile gold has maintained its purchasing power and even increased it, thanks to the bull market over the past twelve years. One dollar of gold purchased in 1913 equals about $2.95 today after inflation.

To understand why gold has been a good store of value relative to other currencies, you need to think in terms of supply and demand. Some gold bears claim that all the gold ever mined is still in existence. This is true. But despite this fact, it is still of limited supply. According to the American Museum of Natural History, all of the gold that has been mined throughout history could fit in a square box measuring 65.5 feet per side. They also point out how hard it is to come by, saying that within the Earth’s crust only one out of one billion atoms of rock is gold.

Compare that limited supply of gold to that of paper currencies like the dollar that have limitless supply. Fed Chairman Ben Bernanke is a much smarter man than I am, so I’ll let him continue with the supply explanation with an excerpt from a speech he gave before the National Economists Club in Washington DC in November 2002:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Gold clearly has a more limited supply relative to paper currencies because no one can print gold, but gold also shares similar advantages in the demand department. Think about the differences. Gold has been desired throughout history over a variety of cultures in a variety of geographic regions. Meanwhile, the only reason you demand dollars is because the government says that they are worth something. Gold proves to be superior from the perspective of demand because the demand for it is real and not manufactured or mandated like it is with paper currencies.

To summarize, gold is a better hedge against inflation and a better store of value than paper currencies because of its superior supply and demand characteristics; therefore, it is a superior currency. With all of the money printing (a.k.a. “stimulus”) that resulted in response to The Great Recession, the market is starting to realize that fact, which is why the price of gold continues to move upward.

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