Why is gold so trusted by investors? Is it because it is backed by a physical asset meaning it has no default risk? The yellow metal has long intrigued and even caused many to lose their heads and risk death by rushing to the Klondike in chase of it. Its hold over us gives rise to a question as to whether it does ‘what it says on the tin’? In the following article, we will highlight whether gold as protection has any substance!
It is important to realise that gold investing was historically the gold coins your great-grand-mother kept in the biscuit tin at the back of the attic behind some old clothes. For wealthier clients, this meant holding gold bars in a vault of a major bank. Today the advent of Exchange Traded Funds (ETFs) means you can buy an exposure to a physically backed gold fund without the cost of holding a physical gold bar.
Gold as protection is seen by some traders as a hedge against inflation. It is universally agreed that it is one solution against systematic risk. The risk that an entire financial system may collapse, which seemed impossible until 2008, is one which few assets can hedge against. Gold is unique, except maybe IMF SDRs, in being beyond formal governmental control.
The hedge against inflation is the traditional motive behind the investment in gold. Its role as an inflation hedge is perhaps the most debated and ambiguous issue in financial markets and academic literature. The truth is that the yellow metal serves as an inflation hedge in the long run, but not in the short run. In the short run, the rise in interest rates makes government bonds more attractive. With the gold price dropping as 10y US treasuries become increasingly attractive as they yield close to 3%.
In the long run (and we are talking decades here) having some exposure to gold is useful as protection against geopolitical events – which contain multiple threats to your trading profits. Once such event is a trade war, especially one involving two large economies, as all currencies suffer loses in this scenario. Ironically the budding trade war we have between the US and China could be just an event to hold gold as protection. A trade war could be just the bad news needed to trigger a sell off in an expensive stock market which has been on a long bull run! The lack of volatility in post-Brexit markets should be a warning to any aspiring trader who is learning to trade and is a proponent of mindful trading.
Cultural biases mean that not everyone sees Gold as protection against a stock market crash. UK stockbrokers have historically shown little love for this precious metal. As a result, apart the occasional gold bug apart, you rarely see it as part of a portfolio. This may be because wealth creation is seen as more important. Swiss private bankers have always attached an importance to gold as protection, due to their belief in wealth preservation. European buyers have recently been increasing their exposure to Gold. US portfolio managers are seemingly rotating out of gold into US 10 year Treasuries!
Gold as protection has its critics, it’s lack of yield means it is seen as missing out on the (unofficial) 8th wonder of the world: compounding. Indeed, with various costs of holding or investing in it, you can lose money by holding it for long periods if it doesn’t rise. You also have the potential of an opportunity loss versus over trading opportunities.
Anecdotally, the trust of the yellow metal is such that if you Google ‘gold as protection’ you find multiple companies offering you their ‘gold standard’ service as if gold should be seen as the benchmark for top quality. As a result of the 2008 financial crisis, gold nearly doubled in value by August 2011. This is investors looking to gold as protection from a collapsing financial system. In a sell-off, the one asset which is the least volatile, and therefore less likely to drop substantially, is the one perceived as having the most quality. Maybe there is a case for gold as protection in any trading strategy?