Gold is a "Hard" Asset
Investing in Gold Financial analysts classify gold as a "hard" asset, meaning that it has value in and of itself. Stocks, bonds, and even cash are categorized as "soft" assets because their value is dependent upon your faith in a third party to support the value of the asset.
In the case of stocks or corporate bonds, the value of the stock or bond is tied directly to the performance of the company that issued it. There is no intrinsic value in a stock or bond certificate. From the perspective of intrinsic value, it is literally worth the paper it is printed on! And the same is true of paper currency. The dollar bill in your wallet is backed by the full faith and credit of the United States Government. If a majority of people were to lose faith in the financial credibility of the United States Government, it would have a direct and adverse affect on the value of that dollar. Not only that, but the dollar is subject to inflation. "A dollar doesn't go as far today as it used to" is a phrase we have heard many times. And it's absolutely true! The value of a dollar will also vary relative to the strength of other world currencies. A U.S. dollar is not worth the same number of English Pounds, Japanese Yen, or Euros from day to day.
Alan Greenspan, testifying before congress, said:
"I do think there is a considerable amount of information about the nature of a domestic currency from observing its price in terms of gold. It is a longer term issue. It is an issue which I think is relevant, and if you don't believe that, you always have to ask the question why it is that central banks hold so much gold which earns no interest and which costs them money to store. The answer is obvious: they consider it of significant value and, indeed, they consider it the ultimate means of payment, one which does not require any form of endorsement. There is something terribly important that the gold price is telling us. I think that disregarding it is to fail to recognize certain crucial aspects of the value of currencies."
Many financial advisors will recommend that a diversified portfolio should have some "hard" assets in addition to "soft" assets. And over thousands of years, gold has proved to be the most popular and enduring "hard" asset in the world.
Gold is a Hedge Against Inflation and a Weakening Dollar
We have not experienced high inflation for the past 20 years and, for some, it may be a distant memory. It's also important to note that current inflation figures produced by the U.S. government exclude oil and food. This produces a lower, more stable number that is also deceiving from a consumer standpoint. There's no getting around the fact that when oil and gas prices go up, your dollar is buying less for you. The more it costs you to heat your house and fill your gas tank, the more money you need to meet basic needs. Nevertheless, gold tends to perform well in times of high inflation.
Gold is an effective tool for preserving wealth against inflation over the long term. This was proven empirically in a 2000 study conducted by the University of Stirling (Scotland). They compared the monthly gold price to the U.S. Retail Index from 1976 - 1999 and concluded that, while short-term results might fluctuate, gold served as a hedge against inflation over the long-term.
Inflation is not the only danger to dollar denominated assets. With the historical and current decline of the dollar against other world currencies our buying power being eroded everyday. Gold is one of the few assets that actually performs better during times of a weakening dollar. The chart below shows the inverse relationship between gold and the USD Index which tracks the buying power of the Dollar against a basket of other currencies.
Gold is a "Safe Haven"
In times of financial turmoil, when our faith in financial institutions - including the government - is strained, the value of gold tends to go up. Below are links to three charts that examine the recent history of gold. You'll note that times of significant difficulty in the world tend to cause gold prices to increase rapidly. They are also likely to fall when relative calm is restored. Nevertheless, gold represents a portion of your portfolio that will increase in value at a time when your other investments are being battered and you're in need of a safe haven.
1972 marked the beginning of a run-up in gold prices from approximately $40 to well over $100, a mark that gold would not dip below again, even with all the market corrections that would subsequently occur. The early 70's marked a period of economic and political turmoil. The Vietnam War was going poorly, President Nixon devalued the dollar and inflation was on the rise. The price of gold continued to rise as the Watergate scandal escalated and led to the eventual resignation of the President. Gold prices temporarily peaked in 1975 at almost $200 with inflation on the rise, OPEC price increases, and the assassination of King Faisal of Saudi Arabia. As the political and economic situation stabilized, gold prices retreated to the $100 level.
This period saw a precipitous rise and a not quite equally precipitous decline in gold prices. Once again, political and economic crisis drove gold prices. Double-digit inflation, double digit lending rates, a recession, a world-wide monetary crisis, and the Iran hostage situation created a gold frenzy that drove prices to their all-time high of $875. With the election of President Reagan and an improved economic outlook, the price of gold retreated significantly but still remained well above its pre-1978 price level.
Our more recent history is fresh in our minds. Economic recession, the attacks of 9/11, decreasing housing prices and the invasion of Iraq laid the foundation for a period of steady increases in the price of gold. While the price of gold is up over 300% since 2000, it is still well below its inflation adjusted high of over $2,200 per ounce.
Gold is a Speculative Investment
Gold prices have risen over time. Some of those increases have occurred suddenly and rapidly. Conversely, the price of gold may also be subject to rapid declines. As a result of this relative volatility, an element of the investing public chooses gold as a speculative investment that will allow them to capitalize on dramatic short term gains, should they arise. While the price of gold is up over 300% since 2000, it is still well below its inflation adjusted high of over $2,200 per ounce.