For millennia gold has played a significant role in human society. From ancient civilizations to modern times, it has been used to showcase status among neighbors, to display power among rulers, and to facilitate trade among nations.
Yet, despite its shiny exterior, it is intrinsically worthless. Outside of its limited uses in electronics and dentistry, gold only has value in human society because it is gold and not something else. This explains why over 80% of annual global gold demand is for jewelry and investment purposes and not for industrial use. We spend most of our time using gold as gold and not as a conductor of electricity or as a replacement for your pearly whites.
But why gold? Why not aluminum? Or iron? Or something else entirely?
And, more importantly, should you be investing in gold? Why or why not?
Why Gold and Not Something Else?
Unlike the many other metals found around the globe, gold has held and retained a high status because of three specific properties: scarcity, durability, and malleability.
Gold wouldn’t be what it is if it were as readily available as aluminum, the most abundant metal in Earth’s crust. However, it also wouldn’t be gold if it was as uncommon as rhodium, a rare Earth metal with one-tenth of gold’s annual production. As Warren Buffett stated in his 2011 letter to shareholders:
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.)
This relationship between gold’s stock and its flow makes it the metaphoric “goldilocks” of Earthly metals— rare enough to be prized, but common enough to be found and utilized throughout the world. Without this relative scarcity, gold might have been just another glittering rock.
However, scarcity alone isn’t enough to give gold its high status. Gold also has the unique property of being one of the most durable metals on the planet. It doesn’t rust. It doesn’t tarnish. And it can only be corroded under very specific circumstances.
You can bury your gold and come back in 50 years (or 50,000 years) and it would be basically unchanged. This is why Peter Bernstein wrote in The Power of Gold:
In Cairo, you will find a tooth bridge made of gold for an Egyptian 4,500 years ago, its condition good enough to go into your mouth today.
The immense durability of gold makes it one of the few things in nature that can act as a true store of value. This is why gold has been used as a currency throughout history—it doesn’t break down through daily use.
In a world where everything we know degrades, this is why gold is literally able to stand the test of time.
Even with its scarcity and durability, gold would have had a much harder time becoming a global phenomenon if not for its unsurpassed malleability. In fact, gold is the most malleable of all metals. It’s so flexible that one ounce can be made into a thin continuous sheet measuring roughly 100 square feet or stretched into a wire over 50 miles long. Pure gold is incredibly soft (for a metal), which allows it to be reshaped with relative ease.
Think about how useful of a quality this is for a store of value. You can divide it, hide it, or transport it from place to place with very little effort. What more could you ask for in a material?
When combined with gold’s scarcity and virtual indestructibility, it’s no wonder that people chased it the world over for centuries. Outside of nailing the trifecta of scarcity, durability, and malleability, gold’s true value comes from embodying the concept of proof of work.
Why Gold is Valuable (Proof of Work)
One of the striking things about gold is just how incredibly hard it is to attain (and hold onto once
you have it) and the different things you have to master to get gold.
To get gold you
— Have to be good at warfare
— Be able to marshall an extensive human workforce to mine it
— Mastery of global supply and logistics routes
— Be able to command guards who will watch your gold, and not steal it
— Have the technical know-how to get gold out of the ground, which is expensive and
cumbersome. And so on…
In other words, when you have gold you’re communicating all the different things you’re capable
of (mastering supply routes, commanding an army, scientific endeavor, marshalling labor, etc.)
Gold, then, is a very specific proof of work. If you can get gold, you’ve proven that you have the
ability to run a state or some state-like entity.
While you don’t need to the ability to “run a state-like entity” today to acquire gold, the idea still holds. What made gold valuable historically (and what makes it valuable today) is not its explicit ownership (i.e. I have a rare, shiny piece of metal), but the implicit message of that ownership (i.e. I have the skills/ability/resources to acquire a rare, shiny piece of metal).
The best example I can provide to illustrate this is the history of aluminum. When aluminum was first discovered in the late 1700s, it was initially more valuable than gold because of how difficult it was to obtain. In fact, aluminum was used to cap the Washington Monument, when it was first completed in 1880.
However, as the refining process improved and aluminum extraction became easier, the once rare metal became much less rare. The increased availability of aluminum decreased its proof of work and, thus, reduced its value relative to gold. What started as the capstone to one of America’s most treasured landmarks eventually became the go-to container for sugar water.
This is the undeniable strength of proof of work. With it, you are admired and, without it, you are ignored. So goes the story of gold.
Now that we have discussed why gold is valuable to society, let’s examine how gold might be valuable to you.
When Gold Became an Investment
For most of modern history gold was used as a currency in some form or fashion. This is why William Bernstein remarked that:
…an ounce of gold bought a fine men’s suit in the time of Shakespeare, and so it does today.
Because gold literally was money, there was no inherent gains to be made from owning it.
However, this all changed after the United States abandoned the gold standard in 1973 and allowed American citizens to, once again, privately own gold in August 1974.
Since then, gold has increased in value from $156 an ounce to around $1,750 today. Adjusting for inflation, gold has doubled its purchasing power since it was decoupled from the U.S. dollar:
However, gold’s growth has been no match for the inflation-adjusted growth of the S&P 500 (with dividends) over the same time period:
You might see a chart like this and ask why someone would ever invest in gold for the long term. However, this misses a bigger point about the value of gold within a portfolio. Before we get to that let’s examine the type of investor who should not invest in gold.
Who Should Not Invest in Gold?
So, you want to own gold for the long run? If so, you better be comfortable with multi-decade drawdowns:
If you aren’t, then welcome to the club. I used to be a gold investor myself, but sold out of it after I realized how difficult it would be to hold an asset over such long periods of time. Even with its price run in recent months, gold is still more than 5% off of its 2011 all time highs.
Additionally, gold has much more volatility with much lower returns than many other similarly-risky asset classes (i.e. equities, REITs, etc.). For example, if we look at a plot of risk versus return for various asset classes, you can see this distinction more clearly:
As you can see, gold seems to break the pattern of “more risk => more reward.”
Lastly, gold also seems to go through periods of boom and bust, which can be hard for many investors to stomach. For example, if you look at the returns by decade starting in 1975, you can see that there are periods where gold struggles and periods where it surges:
Because of this, many investors may decide that, when it comes to gold, the juice just isn’t worth the squeeze.
However, all of the downsides stated above are based on gold’s individual performance, not its performance within a portfolio. Therefore, if you are someone that focuses on individual positions (over portfolio returns) then gold is not likely to be for you.
But, if you can ignore the individual pieces of your portfolio and look at the bigger picture, does gold add value then?
Who Should Invest in Gold?
While most investors, myself included, have been scared away from gold because of its high risk-low reward track record, there are arguments to be made for owning gold due to its ability to add value at the portfolio level.
For example, imagine a portfolio with an equal split into three asset classes: the S&P 500 (33.3%), long-term U.S. bonds (33.3%), and emerging market stocks (33.3%). Now imagine taking that portfolio and adding in gold so that the split went to 25% each, such as: S&P 500 (25%), long-term U.S. bonds (25%), emerging market stocks (25%), and gold (25%).
If you were to compare the growth of these two portfolios, the one with gold would have outperformed:
And it would have done so while, generally, having less overall portfolio risk (standard deviation):
This provides evidence that gold can be a useful component of a portfolio even if it is a scary asset class to hold on its own.
The reasoning for gold’s ability to add value at the portfolio level is its low correlation to other traditional risky asset classes (i.e. stocks). For example, the average correlation of monthly returns between gold and the S&P 500 is basically zero though it has varied historically:
In addition, gold seems to have the ability to de-risk the portfolio when other risky asset classes are getting crushed. For example, compare how gold performed relative to the S&P 500 through the coronavirus crash earlier this year:
For some of that time gold seemed to be going down with the ship, but then it righted itself and resurfaced as equities continued sinking. Unlike our prior example where focusing on gold can be a detriment to the typical investor, this is an example when focusing on gold could be the mental life raft that keeps someone sane.
Of course, this is always easier said than done. Remember that this outperformance over the S&P 500 comes at a time when gold is still in a drawdown from its 2011 highs (9 years ago)! However, if you are able to look past this such periods of lackluster performance (pun intended), then you might want to consider adding some gold into the mix.
Value is in the Eye of the Beholder
So why is gold valuable? Is it its historical demonstration of proof of work? Or its chemical properties that allowed it to rise to such prominence in the first place? Or maybe it’s its modern usage as a portfolio diversifier for global investors?
Maybe it is none of them or maybe it is all of them. The main thing that I learned while researching gold is that value is in the eye of the beholder.
Some of you will see gold as an outdated tool of crazies and conspiracy theorists who own lots of guns and canned goods. Some of you will see gold as the last bastion of hope in a world where the U.S. dollar is certain to implode.
If I had to guess, I would say that the truth is somewhere in the middle. As we digitize our world and find other ways of storing value, gold has more competition than ever before. However, if you think that one of the longest-lived signals demonstrating proof of work in human society is going to be discarded anytime soon, think again.
Invest accordingly and thank you for reading!
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This is post 192. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data